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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549



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FORM 10-Q



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended December 31, 2005



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to



Commission File Number 1-12607



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SUNLINK HEALTH SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Ohio                                                           |  | 31-0621189                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



900 Circle 75
Parkway, Suite 1120, Atlanta, Georgia 30339

(Address of principal executive offices)

(Zip Code)



(770) 933-7000

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filings requirements for the past 90
days.    Yes  x    No ̈



Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.



|                         |  |                    |  |                         
|------------------------ |  | ------------------ |  | ------------------------
|Large accelerated filer ̈ |  | Accelerated filer ̈ |  | Non-accelerated filer  x



Indicate by check mark
whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



The number of Common Shares, without par value, outstanding as of February 10, 2006 was 7,242,578.



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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS



SUNLINK
HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                                                                            |  |                  |        |   |              |   |        |  
|------------------------------------------------------------------------------------------- |  | ---------------- | ------ | - | ------------ | - | ------ | -
|                                                                                            |  | December 31,2005 |        |   | June 30,2005 |  
|ASSETS                                                                                      |  |                  |        |   |              |   |        |  
|Current Assets:                                                                             |  |                  |        |   |              |   |        |  
|Cash and cash equivalents                                                                   |  | $                | 3,606  |   |              | $ | 5,281  |  
|Receivables - net                                                                           |  |                  | 13,809 |   |              |   | 14,549 |  
|Medical supplies                                                                            |  |                  | 2,489  |   |              |   | 2,350  |  
|Deferred income tax asset                                                                   |  |                  | 838    |   |              |   | 1,210  |  
|Prepaid expenses and other                                                                  |  |                  | 2,401  |   |              |   | 1,464  |  
|                                                                                            |  |                  |        |   |              |   |        |  
|Total Current Assets                                                                        |  |                  | 23,143 |   |              |   | 24,854 |  
|                                                                                            |  |                 
|Property, Plant and Equipment, at cost                                                      |  |                  | 46,431 |   |              |   | 43,073 |  
|Less accumulated depreciation and amortization                                              |  |                  | 8,730  |   |              |   | 7,198  |  
|                                                                                            |  |                  |        |   |              |   |        |  
|Property, Plant and Equipment - net                                                         |  |                  | 37,701 |   |              |   | 35,875 |  
|                                                                                            |  |                 
|Goodwill                                                                                    |  |                  | 2,944  |   |              |   | 2,944  |  
|Other assets                                                                                |  |                  | 1,649  |   |              |   | 1,767  |  
|                                                                                            |  |                  |        |   |              |   |        |  
|Total Assets                                                                                |  | $                | 65,437 |   |              | $ | 65,440 |  
|                                                                                            |  |                  |        |   |              |   |        |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                        |  |                  |        |   |              |   |        |  
|Current Liabilities:                                                                        |  |                  |        |   |              |   |        |  
|Accounts payable                                                                            |  | $                | 5,883  |   |              | $ | 6,075  |  
|Third-party payor settlements                                                               |  |                  | 5,101  |   |              |   | 3,733  |  
|Current maturities of long-term debt                                                        |  |                  | 933    |   |              |   | 843    |  
|Accrued payroll and related taxes                                                           |  |                  | 3,806  |   |              |   | 4,821  |  
|Income taxes                                                                                |  |                  |       |   |              |   | 893    |  
|Other accrued expenses                                                                      |  |                  | 4,452  |   |              |   | 5,336  |  
|                                                                                            |  |                  |        |   |              |   |        |  
|Total Current Liabilities                                                                   |  |                  | 20,175 |   |              |   | 21,701 |  
|                                                                                            |  |                 
|Long-Term Liabilities:                                                                      |  |                  |        |   |              |   |        |  
|Long-term debt                                                                              |  |                  | 8,925  |   |              |   | 9,199  |  
|Noncurrent liability for professional liability risks                                       |  |                  | 3,431  |   |              |   | 3,966  |  
|Noncurrent liabilities of discontinued operations                                           |  |                  | 1,241  |   |              |   | 1,273  |  
|                                                                                            |  |                  |        |   |              |   |        |  
|Total Long-term Liabilities                                                                 |  |                  | 13,597 |   |              |   | 14,438 |  
|                                                                                            |  |                 
|Commitments and Contingencies                                                               |  |                  |        |   |              |   |        |  
|                                                                                            |  |                 
|Shareholders Equity:                                                                       |  |                  |        |   |              |   |        |  
|Preferred shares, authorized and unissued, 2,000 shares                                     |  |                  |        |   |              |   |        |  
|Common shares, without par value:                                                           |  |                  |        |   |              |   |        |  
|Issued and outstanding, 7,243 shares at December 31, 2005 and 7,198 shares at June 30, 2005 |  |                  | 3,621  |   |              |   | 3,599  |  
|Additional paid-in capital                                                                  |  |                  | 7,891  |   |              |   | 7,589  |  
|Retained earnings                                                                           |  |                  | 20,641 |   |              |   | 18,636 |  
|Accumulated other comprehensive loss                                                        |  |                  | (488   | ) |              |   | (523   | )
|                                                                                            |  |                  |        |   |              |   |        |  
|Total Shareholders Equity                                                                  |  |                  | 31,665 |   |              |   | 29,301 |  
|                                                                                            |  |                  |        |   |              |   |        |  
|Total Liabilities and Shareholders Equity                                                  |  | $                | 65,437 |   |              | $ | 65,440 |  
|                                                                                            |  |                  |        |   |              |   |        |  



See notes to condensed consolidated
financial statements.



2



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SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(in thousands, except per share amounts)

(unaudited)



|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------- |  | ------------------------------ | ------ | - | ---------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                        |  | THREE MONTHS ENDEDDecember 31, |        |   | SIX MONTHS ENDEDDecember 31, |  
|                                                        |  | 2005                           |        |   | 2004                         |   |        | 2005 |  |   | 2004   |  
|Net Revenues                                            |  | $                              | 32,242 |   |                              | $ | 31,291 |      |  | $ | 66,141 |   |  | $ | 61,748 |  
|                                                        |  |                                |        |  
|Cost of Patient Service Revenues:                       |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Salaries, wages and benefits                            |  |                                | 16,171 |   |                              |   | 15,068 |      |  |   | 32,346 |   |  |   | 29,724 |  
|Provision for bad debts                                 |  |                                | 3,519  |   |                              |   | 3,264  |      |  |   | 7,387  |   |  |   | 6,271  |  
|Supplies                                                |  |                                | 3,529  |   |                              |   | 3,456  |      |  |   | 7,151  |   |  |   | 6,925  |  
|Purchased services                                      |  |                                | 2,082  |   |                              |   | 1,860  |      |  |   | 4,232  |   |  |   | 3,590  |  
|Other operating expenses                                |  |                                | 3,599  |   |                              |   | 5,085  |      |  |   | 8,352  |   |  |   | 10,385 |  
|Rent and lease expense                                  |  |                                | 604    |   |                              |   | 641    |      |  |   | 1,222  |   |  |   | 1,584  |  
|Depreciation and amortization                           |  |                                | 784    |   |                              |   | 589    |      |  |   | 1,552  |   |  |   | 1,223  |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Cost of patient service revenues                        |  |                                | 30,288 |   |                              |   | 29,963 |      |  |   | 62,242 |   |  |   | 59,702 |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Operating Profit                                        |  |                                | 1,954  |   |                              |   | 1,328  |      |  |   | 3,899  |   |  |   | 2,046  |  
|                                                        |  |                                |        |  
|Other Income (Expense):                                 |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Interest expense                                        |  |                                | (286   | ) |                              |   | (276   | )    |  |   | (561   | ) |  |   | (596   | )
|Interest income                                         |  |                                | 19     |   |                              |   | 12     |      |  |   | 39     |   |  |   | 25     |  
|Loss on early repayment of debt                         |  |                                |       |   |                              |   | (384   | )    |  |   |       |   |  |   | (384   | )
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Earnings From Continuing Operations before Income Taxes |  |                                | 1,687  |   |                              |   | 680    |      |  |   | 3,377  |   |  |   | 1,091  |  
|                                                        |  |                                |        |  
|Income Tax Expense                                      |  |                                | 770    |   |                              |   | 28     |      |  |   | 1,376  |   |  |   | 116    |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Earnings From Continuing Operations                     |  |                                | 917    |   |                              |   | 652    |      |  |   | 2,001  |   |  |   | 975    |  
|                                                        |  |                                |        |  
|Earnings (Loss) from Discontinued Operations            |  |                                | (15    | ) |                              |   | 37     |      |  |   | 4      |   |  |   | 23     |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Net Earnings                                            |  | $                              | 902    |   |                              | $ | 689    |      |  | $ | 2,005  |   |  | $ | 998    |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Earnings Per Share:                                     |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Continuing Operations:                                  |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                   |  | $                              | 0.13   |   |                              | $ | 0.09   |      |  | $ | 0.28   |   |  | $ | 0.14   |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                                 |  | $                              | 0.12   |   |                              | $ | 0.08   |      |  | $ | 0.26   |   |  | $ | 0.13   |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Net Earnings:                                           |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                   |  | $                              | 0.12   |   |                              | $ | 0.10   |      |  | $ | 0.28   |   |  | $ | 0.14   |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                                 |  | $                              | 0.11   |   |                              | $ | 0.09   |      |  | $ | 0.26   |   |  | $ | 0.13   |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Weighted-Average Common Shares Outstanding:             |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                   |  |                                | 7,242  |   |                              |   | 7,162  |      |  |   | 7,224  |   |  |   | 7,168  |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                                 |  |                                | 7,860  |   |                              |   | 7,673  |      |  |   | 7,825  |   |  |   | 7,687  |  
|                                                        |  |                                |        |   |                              |   |        |      |  |   |        |   |  |   |        |  



See notes to condensed consolidated
financial statements.



3



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SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                 |  |                              |        |   |      |   |        |  
|---------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                                                 |  | SIX MONTHS ENDEDDecember 31, |       
|                                                                 |  | 2005                         |        |   | 2004 |  
|Net Cash Provided By (Used In) Operating Activities              |  | $                            | 1,775  |   |      | $ | (2,831 | )
|                                                                 |  |                             
|Cash Flows From Investing Activities:                            |  |                              |        |   |      |   |        |  
|Expenditures for property, plant and equipment                   |  |                              | (3,110 | ) |      |   | (1,192 | )
|                                                                 |  |                              |        |   |      |   |        |  
|Net Cash Used in Investing Activities                            |  |                              | (3,110 | ) |      |   | (1,192 | )
|                                                                 |  |                             
|Cash Flows From Financing Activities:                            |  |                              |        |   |      |   |        |  
|Proceeds from issuance of common shares under stock option plans |  |                              | 116    |   |      |   | 25     |  
|Proceeds from long-term debt                                     |  |                              |       |   |      |   | 10,000 |  
|Revolving advances, net                                          |  |                              |       |   |      |   | (2,591 | )
|Payments on long-term debt                                       |  |                              | (456   | ) |      |   | (6,944 | )
|                                                                 |  |                              |        |   |      |   |        |  
|Net Cash Provided by (Used in) Financing Activities              |  |                              | (340   | ) |      |   | 490    |  
|                                                                 |  |                              |        |   |      |   |        |  
|Net Decrease in Cash and Cash Equivalents                        |  |                              | (1,675 | ) |      |   | (3,533 | )
|                                                                 |  |                             
|Cash and Cash Equivalents at Beginning of Year                   |  |                              | 5,281  |   |      |   | 7,079  |  
|                                                                 |  |                              |        |   |      |   |        |  
|Cash and Cash Equivalents at End of Period                       |  | $                            | 3,606  |   |      | $ | 3,546  |  
|                                                                 |  |                              |        |   |      |   |        |  
|Supplemental Disclosure of Cash Flow Information:                |  |                              |        |   |      |   |        |  
|                                                                 |  |                             
|Cash Paid For:                                                   |  |                              |        |   |      |   |        |  
|Interest                                                         |  | $                            | 555    |   |      | $ | 489    |  
|                                                                 |  |                              |        |   |      |   |        |  
|Income taxes                                                     |  | $                            | 2,880  |   |      | $ | 3,873  |  
|                                                                 |  |                              |        |   |      |   |        |  
|Non-cash investing and financing activities - Capital leases     |  | $                            | 272    |   |      | $ |       |  
|                                                                 |  |                              |        |   |      |   |        |  



See notes to condensed consolidated
financial statements.



4



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SUNLINK HEALTH SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND SIX MONTHS
ENDED DECEMBER 31, 2005

(all dollar amounts in thousands, except per share amounts)

(unaudited)



Note 1. - Basis of Presentation



The accompanying unaudited Condensed Consolidated Financial Statements as of and for the three and six months periods ended December 31, 2005 have been prepared in
accordance with Rule 10-01 of Regulation S-X of the Securities and Exchange Commission (SEC) and, as such, do not include all information required by accounting principles generally accepted in the United States of America. These
Condensed Consolidated Financial Statements should be read in conjunction with the audited consolidated financial statements included in the SunLink Health Systems, Inc. (SunLink, we, our, ours,
us or the Company) Annual Report on Form 10-K for the fiscal year ended June 30, 2005, filed with the SEC on September 16, 2005. In the opinion of management, the Condensed Consolidated Financial Statements, which
are unaudited, include all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position and results of operations for the periods indicated. The results of operations for the three and six month
periods ended December 31, 2005 are not necessarily indicative of the results that may be expected for the entire fiscal year or any other interim period.



Note 2.  Business Operations and Corporate Strategy



SunLink is a provider of healthcare services through the operation of exurban and rural community hospitals in the United States. In February 2001, SunLink acquired its
initial six hospitals and began healthcare operations. On October 3, 2003, SunLink acquired two additional hospitals pursuant to its acquisition of HealthMont, Inc. (HealthMont). On June 1, 2004, SunLink sold its Mountainside
Medical Center (Mountainside) facility, a 35-bed hospital located in Jasper, Georgia. Through its subsidiaries, SunLink operates a total of seven community hospitals in four states. Six of the hospitals are owned and one is leased.
SunLink also operates certain related businesses, consisting primarily of nursing homes located adjacent to, or in close proximity with, certain of its hospitals, and home health agencies servicing areas around its hospitals. The healthcare
operations comprise a single business segment: community hospitals. SunLink currently does not have operations in other business segments. SunLinks hospitals are acute care hospitals and have a total of 402 licensed beds.



SunLinks business strategy is to focus its efforts on internal growth of its seven
hospitals supplemented by growth from selected hospital acquisitions. During the six months ended December 31, 2005, SunLink concentrated its efforts on the operation and improvement of its existing hospitals. During the current fiscal year,
SunLink has evaluated certain hospitals which were for sale and monitored selected hospitals which SunLink has determined might become available for sale. SunLink continues to engage in similar evaluation and monitoring activities with respect to
hospitals which are or may become available for acquisition.



Note 3. 
Discontinued Operations



All of the businesses discussed below are
reported as discontinued operations and the condensed consolidated financial statements for all prior periods have been adjusted to reflect this presentation.



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Results for all of the businesses included in discontinued operations are presented in
the following table:



|                                                             |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  
|------------------------------------------------------------ |  | ------------------------------ | --- | - | ---------------------------- | - | --- | ---- |  | - | ---- | - |  | - | --- | -
|                                                             |  | Three Months EndedDecember 31, |     |   | Six Months EndedDecember 31, |  
|                                                             |  | 2005                           |     |   | 2004                         |   |     | 2005 |  |   | 2004 |  
|Earnings (Loss) from discontinued operations:                |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  
|                                                             |  |                                |     |  
|Mountainside Medical Center:                                 |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  
|Earnings (Loss) from operations                              |  | $                              | (20 | ) |                              | $ | 51  |      |  | $ | 18   |   |  | $ | 51  |  
|Income tax (expense)                                         |  |                                | 11  |   |                              |   |    |      |  |   | (2   | ) |  |   |    |  
|                                                             |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  
|Earnings (Loss) from Mountainside Medical Center after taxes |  |                                | (9  | ) |                              |   | 51  |      |  |   | 16   |   |  |   | 51  |  
|Life sciences and engineering segment:                       |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  
|Loss from operations                                         |  |                                | (6  | ) |                              |   | (14 | )    |  |   | (12  | ) |  |   | (28 | )
|                                                             |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  
|Earnings (Loss) from discontinued operations                 |  | $                              | (15 | ) |                              | $ | 37  |      |  | $ | 4    |   |  | $ | 23  |  
|                                                             |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  



Mountainside Medical
Center  On June 1, 2004, SunLink completed the sale of its Mountainside Medical Center hospital in Jasper, Georgia, for approximately $40,000 pursuant to the terms of an asset sale agreement. Under the terms of the agreement,
SunLink sold the operations of Mountainside, which included the property, plant and equipment and the supplies inventory. SunLink retained Mountainsides working capital except for supplies inventory. The retained assets and liabilities of
Mountainside are shown in Other assets and Other accrued expenses on the consolidated balance sheet.



Life Sciences and Engineering Segment  SunLink retained a defined benefit retirement plan which covered substantially all of the employees of this segment when it was sold in fiscal 1998. Effective
February 28, 1997, the plan was amended to freeze participant benefits and close the plan to new participants. Included in discontinued operations for the three and six months ended December 31, 2005 and 2004, respectively, were the
following:



|                                   |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  
|---------------------------------- |  | ------------------------------ | --- | - | ---------------------------- | - | --- | ---- |  | - | ---- | - |  | - | --- | -
|                                   |  | Three Months EndedDecember 31, |     |   | Six Months EndedDecember 31, |  
|                                   |  | 2005                           |     |   | 2004                         |   |     | 2005 |  |   | 2004 |  
|Service cost                       |  | $                              |    |   |                              | $ |    |      |  | $ |     |   |  | $ |    |  
|Interest cost                      |  |                                | 23  |   |                              |   | 21  |      |  |   | 46   |   |  |   | 42  |  
|Expected return on assets          |  |                                | (22 | ) |                              |   | (14 | )    |  |   | (44  | ) |  |   | (28 | )
|Amortization of prior service cost |  |                                | 5   |   |                              |   | 7   |      |  |   | 10   |   |  |   | 14  |  
|                                   |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  
|Net pension expense                |  | $                              | 6   |   |                              | $ | 14  |      |  | $ | 12   |   |  | $ | 28  |  
|                                   |  |                                |     |   |                              |   |     |      |  |   |      |   |  |   |     |  



SunLink did not contribute to the plan
in the six months ended December 31, 2005. We expect to contribute $200 to the plan through the end of the fiscal year ending June 30, 2006.



Housewares Segment - Beldray Limited (Beldray), SunLinks U.K. housewares subsidiary, was sold on October 5, 2001 to two of its
managers for nominal consideration. KRUG International U.K. Ltd. (KRUG UK), an inactive U.K. subsidiary of SunLink, entered into a guarantee (the Beldray Guarantee), at a time when it owned Beldray, a U.K.
manufacturing



6



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business. The Beldray Guarantee covers Beldrays obligations under a lease of a portion of Beldrays
manufacturing location. In October 2004, KRUG UK received correspondence from the landlord of such facility stating that the rent payment of 94,000 British pounds ($181) for the fourth quarter of 2004 had not been paid by Beldray and requesting
payment of such amount pursuant to the Beldray Guarantee. In January 2005, KRUG UK received further correspondence from the landlord demanding two quarterly rent payments totaling 188,000 British pounds ($362) under the Beldray Guarantee. In January
2005, the landlord filed a petition in the High Court of Justice Chancery Division to wind up KRUG UK under the provisions of the Insolvency Act of 1986 and KRUG UK was placed into involuntary liquidation by the High Court in February 2005.



SunLinks non-current liability reserves for discontinued operations at
December 31, 2005, included $1,105 for a portion of the Beldray Guarantee. Such reserve was based upon managements estimate, after consultation with its property consultants and legal counsel, of the cost to satisfy the Beldray Guarantee
in light of KRUG UKs limited assets and before taking into account any other claims against KRUG UK. The maximum potential obligation of KRUG UK for rent under the Beldray Guarantee is estimated to be approximately $8,400. As a result of this
claim and the U.K. liquidation proceedings against KRUG UK, SunLink expects KRUG UK to be wound-up in liquidation in the UK and has fully reserved for any assets of KRUG UK.



Industrial Segment - In fiscal 1989, SunLink discontinued the operations of its industrial segment and subsequently disposed
of substantially all related net assets. However, obligations may remain relating to product liability claims for products sold prior to the disposal.



Discontinued Operations Reserves-Over the past sixteen years SunLink has discontinued operations carried on by its former Mountainside Medical
Center and its former industrial, U.K. leisure marine, life sciences and engineering, and European child safety segments, as well as the U.K. housewares segment. SunLinks reserves relating to discontinued operations of these segments represent
managements best estimate of SunLinks possible liability for property, product liability and other claims for which SunLink may incur liability. These estimates are based on managements judgments, using currently available
information, as well as, in certain instances, consultation with its insurance carriers and legal counsel. While estimates have been based on the evaluation of available information, it is not possible to predict with certainty the ultimate outcome
of many contingencies relating to discontinued operations. SunLink intends to adjust its estimates of the reserves as additional information is developed and evaluated. However, management believes that the final resolution of these contingencies
will not have a material adverse impact on the financial position, cash flows or results of operations of SunLink.



Note 4.  Stock-Based Compensation



SunLink adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment,
effective July 1, 2005. SFAS No. 123 (R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs
liabilities in exchange for goods or services that are based on the fair value of the entitys equity instruments or that may be settled by the issuance of such equity instruments. This Statement focuses primarily on accounting for transactions
in which an entity obtains employee services in share-based payment transactions such as stock options. The effect of adoption of this standard by the Company for the three and six months ended December 31, 2005 was an increase of $151 and
$209, respectively, in salaries, wages and benefit expense for stock options issued to employees and directors of the Company. The fair value of the stock options granted were estimated using the Black-Scholes option pricing model.



7



---

Prior to the adoption of SFAS No. 123 (R) on July 1, 2005, SunLink measured compensation costs for stock
options issued to employees and directors under the intrinsic value method established by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Pro forma net earnings and net
earnings per share amounts that would have resulted had compensation costs been determined using the fair value-based method in the prior year are as follows:



|                                                                                                                    |  |                                |      |                              |   |     
|------------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ---- | ---------------------------- | - | ----
|                                                                                                                    |  | Three Months EndedDecember 31, |      | Six Months endedDecember 31,
|                                                                                                                    |  | 2004                           |      | 2004                        
|Net earnings as reported:                                                                                           |  | $                              | 689  |                              | $ | 998 
|                                                                                                                    |  |                               
|Less: total stock-based compensation determined under the fair value-based method for all awards, net of income tax |  |                                | 8    |                              |   | 16  
|                                                                                                                    |  |                                |      |                              |   |     
|Pro forma net earnings                                                                                              |  | $                              | 681  |                              | $ | 982 
|                                                                                                                    |  |                                |      |                              |   |     
|Net earnings per share attributable to common shareholders:                                                         |  |                                |      |                              |   |     
|                                                                                                                    |  |                               
|Basic:                                                                                                              |  |                                |      |                              |   |     
|As reported                                                                                                         |  | $                              | 0.10 |                              | $ | 0.14
|                                                                                                                    |  |                                |      |                              |   |     
|Pro forma                                                                                                           |  | $                              | 0.10 |                              | $ | 0.14
|                                                                                                                    |  |                                |      |                              |   |     
|Diluted:                                                                                                            |  |                                |      |                              |   |     
|As reported                                                                                                         |  | $                              | 0.09 |                              | $ | 0.13
|                                                                                                                    |  |                                |      |                              |   |     
|Pro forma                                                                                                           |  | $                              | 0.09 |                              | $ | 0.13
|                                                                                                                    |  |                                |      |                              |   |     



Note 5.  Recent Accounting
Pronouncements



In December 2004, FASB issued SFAS No. 153,
Exchanges of Nonmonetary Assets  an amendment of APB Opinion No. 29. The guidance in Accounting Principles Board (APB) Opinion No. 29, Accounting for Nonmonetary Transactions, is
based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in that Opinion, however, included certain exceptions to that principle. SFAS No. 153 amends APB
Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has
commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This statement was effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15,
2005. Its adoption by the Company did not have a material impact on the Companys financial condition or results of operations.



In December 2004, FASB issued SFAS No. 123 (revised 2004), Share-Based Payment.SFAS No. 123 (R) replaces SFAS No. 123,
Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123 (R) establishes standards for the accounting for transactions in
which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entitys equity instruments
or that may be settled by the issuance of such equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Company adopted this standard
effective July 1, 2005. The effect of adoption of this standard by the Company for the fiscal year ending June 30, 2006 is estimated to be a decrease of approximately $550 in results of operations.



8



---

In March 2005, FASB published FASB Interpretation No. 47, Accounting for Conditional Asset Retirement
Obligation  an interpretation of FASB Statement No. 143. Interpretation 47 is intended to result in (a) more consistent recognition of liabilities relating to asset retirement obligations, (b) more information about
expected future cash outflows associated with those obligations, and (c) more information about investments in long-lived assets because additional asset retirement costs will be recognized as part of the carrying amounts of the assets.
Interpretation 47 clarifies that the term conditional asset retirement obligation as used in FASB Statement No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement
activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty
exists about the timing and (or) method of settlement. Uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information
exists. Interpretation 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation 47 is effective no later than the end of fiscal years ending after
December 15, 2005. Its adoption by the Company should not have a material impact on the Companys consolidated financial statements.



In June 2005, FASB issued SFAS No. 154, Accounting Changes and Error Correction, a replacement of APB Opinion No. 20 and SFAS No. 3.This statement applies to all voluntary changes in accounting principle and changes the requirements for accounting for and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior
periods financial statements of a voluntary change in accounting principle unless it is impracticable. APB Opinion No. 20 previously required that most voluntary changes in accounting principles be recognized by including in net income
for the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 is intended to improve financial reporting because its requirements enhance the consistency of financial information between periods.
SFAS No. 154 requires that a change in method of depreciation, amortization, and depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate that is effected by a change in accounting principle. APB
Opinion No. 20 previously required that such a change be reported as a change in accounting principles. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
The Statement does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of SFAS No. 154. Implementation of this Standard is not expected to have
a material impact on the consolidated financial statements of the Company.



In
November 2005, the FASB issued FASB Staff Position No. 45-3, Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners (FSP FIN 45-3). The guidance in
this staff position amends FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45) by adding minimum
revenue guarantees to the list of example contracts to which FIN 45 applies. Under FSP FIN 45-3, a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the
guarantee. One example cited in FSP FIN 45-3 involves a guarantee provided by a healthcare entity to a non-employed physician in order to recruit such physician to move to the entitys geographical area and establish a private practice. In the
example, the healthcare entity also agreed to make payments to the relocated physician if the gross revenue or gross receipts generated by the physicians new practice during a specified time period did not equal or exceed predetermined
monetary thresholds.



9



---

FSP FIN 45-3 is effective for new minimum revenue guarantees issued or modified on or after January 1, 2006. The
Company adopted FSP FIN 45-3 effective January 1, 2006. SunLinks accounting policy for physician guarantees issued prior to January 1, 2006 is to expense guarantees as they are paid. However, under FSP FIN 45-3, the Company will
expense the advances paid to physicians over the period of the physician recruiting agreement, which is typically two to three years. The Company is currently assessing the impact of adoption of FSP FIN 45-3 on the consolidated financial
statements.



In November 2005, FASB issued Staff Position (FSP)
Nos. FAS 115-1 and FAS 124-1, The Meaning of Other Than Temporary Impairment and its Application to Certain Investments. This FSP addresses the determination as to when an investment is considered impaired, whether that impairment
is other than temporary, and the measurement of the impairment loss. This Staff Position is effective for periods beginning after December 15, 2005 with earlier application permitted. Implementation of this guidance is not expected to have a
material impact on the consolidated financial statements of the Company.



Note 6.  Receivables- net



Summary information for receivables is as follows:



|                                                            |  |                  |        |   |              |   |        |  
|----------------------------------------------------------- |  | ---------------- | ------ | - | ------------ | - | ------ | -
|                                                            |  | December 31,2005 |        |   | June 30,2005 |  
|Patient accounts receivable (net of contractual allowances) |  | $                | 21,446 |   |              | $ | 21,814 |  
|Less allowance for doubtful accounts                        |  |                  | (7,637 | ) |              |   | (7,270 | )
|                                                            |  |                  |        |   |              |   |        |  
|Patient accounts receivable, net                            |  |                  | 13,809 |   |              |   | 14,544 |  
|                                                            |  |                 
|Other accounts receivable                                   |  |                  | -      |   |              |   | 5      |  
|                                                            |  |                  |        |   |              |   |        |  
|Receivables - net                                           |  | $                | 13,809 |   |              | $ | 14,549 |  
|                                                            |  |                  |        |   |              |   |        |  



Net revenues included reductions of
$462 and $152 for the three months ended December 31, 2005 and 2004, respectively, for the settlements and filings of prior year Medicare and Medicaid cost reports. Net revenues included increases of $258 and $7 for the six months ended
December 31, 2005 and 2004, respectively, for the settlements and filings of prior year Medicare and Medicaid cost reports.



Note 7.  Long-Term Debt



Long-term debt consisted of the following:



|                          |  |                  |       |   |              |   |        |  
|------------------------- |  | ---------------- | ----- | - | ------------ | - | ------ | -
|                          |  | December 31,2005 |       |   | June 30,2005 |  
|SunLink Term Loan A       |  | $                | 9,222 |   |              | $ | 9,556  |  
|Capital lease obligations |  |                  | 636   |   |              |   | 486    |  
|                          |  |                  |       |   |              |   |        |  
|                          |  |                  | 9,858 |   |              |   | 10,042 |  
|Less current maturities   |  |                  | (933  | ) |              |   | (843   | )
|                          |  |                  |       |   |              |   |        |  
|                          |  | $                | 8,925 |   |              | $ | 9,199  |  
|                          |  |                  |       |   |              |   |        |  



SunLink Credit Facility - On
October 15, 2004, SunLink entered into a $30,000 five-year senior secured credit facility comprised of a revolving line of credit of up to $15,000 with an interest rate at LIBOR plus 2.91%, a $10,000 term loan (SunLink Term Loan A)
with an interest rate at



10



---

LIBOR plus 3.91% and a $5,000 term loan facility (SunLink Term Loan B) with an interest rate at LIBOR plus
3.91%. The revolving line of credit and the SunLink Term Loan A were immediately available to the Company as of October 15, 2004. The SunLink Term Loan B closed on November 15, 2004. The $10,000 SunLink Term Loan A and draws under the
$5,000 SunLink Term Loan B are repayable based on a 15-year amortization from the date of draw with final balloon payments due at the end of the five-year maturity of the credit facility. The total availability under all components of the credit
facility is keyed to the level of SunLinks earnings, which would have provided for current total borrowing capacity at December 31, 2005 of approximately $29,222. As of December 31, 2005, only the SunLink Term Loan A was drawn, of
which $9,222 was outstanding. The proceeds were used to repay outstanding debt in the approximate total amount of $7,700. SunLink may use the remaining funds from the initial draw and the funds available from the revolving line of credit for
hospital capital projects and equipment purchases and for working capital needs. The Company expects to begin using the revolving line of credit during the fiscal year ending June 30, 2006. Borrowing under the $5,000 SunLink Term Loan B may be
used, subject to satisfaction of certain covenants, to satisfy certain specified claims and obligations, to fund acquisitions or to reacquire the Companys securities. Costs and fees related to execution of the credit facility were $916. The
credit facility is secured by a first priority security interest in all assets and properties, real and personal, of the Company and its consolidated domestic subsidiaries, including a pledge of all of the equity interests in such subsidiaries.



Note 8.  Income Taxes



Income tax expense of $770 ($774 federal expense and $4 state benefit) and $28 (all state
taxes) was recorded for the three months ended December 31, 2005 and 2004, respectively. The $774 federal tax expense for the three months ended December 31, 2005 included $742 deferred income tax expense. Income tax expense of $1,376
($1,229 federal and $147 state tax expense) and $116 (all state taxes) was recorded for the six months ended December 31, 2005 and 2004, respectively. The $1,229 federal tax expense for the six months ended December 31, 2005 included $372
deferred income tax expense. We had an estimated net operating loss carry-forward for federal income tax purposes of approximately $8,200 at December 31, 2005. Use of this net operating loss carry-forward is subject to the limitations of the
provisions of Internal Revenue Code Section 382. As a result, not all of the net operating loss carry-forward is available to offset federal taxable income in the current year. At December 31, 2005, we have provided a partial valuation
allowance of the deferred tax so that the net domestic tax asset was $838. Based upon managements assessment that it was more likely than not that a portion of its domestic deferred tax asset (primarily its domestic net operating losses
subject to limitation) would not be recovered, the Company established a valuation allowance for the portion of the domestic tax asset which may not be utilized. The Company has provided a valuation allowance for the entire amount of the foreign tax
asset as it is more likely than not that none of the foreign deferred tax assets will be realized through future taxable income or implementation of tax planning strategies.



11



---

Note 9. - Comprehensive Earnings



Comprehensive earnings for SunLink include foreign currency translation adjustments. Total comprehensive earnings for the following periods
were as follows:



|                                         |  |                    |     |                  |                  |      |                   |  |                   |       |  |   |      |  
|---------------------------------------- |  | ------------------ | --- | ---------------- | ---------------- | ---- | ----------------- |  | ----------------- | ----- |  | - | ---- | -
|                                         |  | Three Months Ended |     |                  | Six Months Ended |     
|                                         |  | December 31, 2005  |     | December 31,2004 |                  |      | December 31, 2005 |  | December 31, 2004 |      
|Net earnings:                            |  | $                  | 902 |                  | $                | 689  |                   |  | $                 | 2,005 |  | $ | 998  |  
|Other comprehensive income net of tax:   |  |                    |     |                  |                  |      |                   |  |                   |       |  |   |      |  
|Change in equity due to :                |  |                    |     |                  |                  |      |                   |  |                   |       |  |   |      |  
|Foreign currency translation adjustments |  |                    | 13  |                  |                  | (123 | )                 |  |                   | 35    |  |   | (123 | )
|                                         |  |                    |     |                  |                  |      |                   |  |                   |       |  |   |      |  
|Comprehensive earnings                   |  | $                  | 915 |                  | $                | 566  |                   |  | $                 | 2,040 |  | $ | 875  |  
|                                         |  |                    |     |                  |                  |      |                   |  |                   |       |  |   |      |  



Note 10. - Commitments and
Contingencies



As discussed in Note 3  Discontinued
Operations, SunLink sold its former U.K. subsidiary, Beldray Limited (Beldray), to two of its managers in October 2001. Beldray has since entered into administrative receivership and is under the administration of its
primary lender. SunLink believes Beldray ceased to operate in October 2004.



As
previously disclosed, KRUG International U.K. Ltd. (KRUG UK), an inactive U.K. subsidiary of SunLink, entered into a guarantee (the Beldray Guarantee), at a time when it owned Beldray, a U.K. manufacturing business.
The Beldray Guarantee covers Beldrays obligations under a lease of a portion of Beldrays manufacturing location. In October 2004, KRUG UK received correspondence from the landlord of such facility stating that the rent payment of 94,000
British pounds ($181) for the fourth quarter of 2004 had not been paid by Beldray and requesting payment of such amount pursuant to the Beldray Guarantee. In January 2005, KRUG UK received further correspondence from the landlord demanding two
quarterly rent payments totaling 188,000 British pounds ($362) under the Beldray Guarantee. In January 2005, the landlord filed a petition in the High Court of Justice Chancery Division to wind up KRUG UK under the provisions of the Insolvency Act
of 1986 and KRUG UK was placed into involuntary liquidation by the High Court in February 2005.



SunLinks non-current liability reserves for discontinued operations at December 31, 2005, included $1,105 for a portion of the Beldray Guarantee. Such reserve was based upon managements estimate,
after consultation with its property consultants and legal counsel, of the cost to satisfy the Beldray Guarantee in light of KRUG UKs limited assets and before taking into account any other claims against KRUG UK. The maximum potential
obligation of KRUG UK for rent under the Beldray Guarantee is estimated to be approximately $8,400. As a result of this claim and the U.K. liquidation proceedings against KRUG UK, SunLink expects KRUG UK to be wound-up in liquidation in the UK and
has fully reserved for any assets of KRUG UK.



SunLink currently utilizes three
different management information systems at our seven hospitals. Five hospitals utilize comprehensive systems designed for larger hospitals and two hospitals utilize a system designed for smaller hospitals. We are converting our hospitals to a
single



12



---

management information system with implementation scheduled to be completed before expiration of our existing software
lease and support agreements which have unexpired terms of up to six months. In June 2005, SunLink entered into a license and support agreement with a management information system company for the single management information system with an
estimated cost of $2,800 for software, installation, training and support. In July 2005, SunLink entered into a capital lease for computers and other hardware for the new system with a total commitment of approximately $273. The total cost of the
software licenses, hardware, installation and training for the new management information system is estimated to be $3,200, approximately $2,500 of which is expected to be capitalized and amortized over the estimated useful life of the new system,
which is 4 years for hardware and 7 years for the licenses and installation. This conversion began in the fiscal quarter ended September 30, 2005 and is expected to be completed by September 30, 2006.



As of December 31, 2005, SunLink had no material future commitments for capital
expenditures except for the management information system conversion project discussed in the previous paragraph. Subject to the availability of internally generated funds and other financing, SunLink currently expects to spend approximately $1,900
in capital expenditures during the remaining six months of the fiscal year ending June 30, 2006, primarily for new and replacement equipment and the management information system conversion project.



SunLinks strategy is to focus its efforts on internal growth of its seven hospitals
supplemented by growth from selected acquisitions. Subject to the availability of debt and/or equity capital, SunLinks internal growth may include replacement or expansion of its existing hospitals involving substantial capital expenditures as
well as the expenditure of significant amounts of capital for selected hospital acquisitions.



SunLink is a party to claims and litigation incidental to its business, for which it is not currently possible to determine the ultimate liability, if any. Based on an evaluation of information currently available and
consultation with legal counsel, management believes that resolution of such claims and litigation is not likely to have a material effect on the financial position, cash flows, or results of operations of the Company. The Company expenses legal
costs as they are incurred.



Contractual Obligations, Commitments and
Contingencies



Contractual obligations, commitments and contingencies
related to long-term debt, non-cancelable operating leases and physician guarantees from continuing operations at December 31, 2005 were as follows:



|                  |  |               |       |                 |   |                     |  |   |      
|----------------- |  | ------------- | ----- | --------------- | - | ------------------- |  | - | -----
|                  |  | Long-TermDebt |       | OperatingLeases |   | PhysicianGuarantees
|Payments due in:  |  |               |       |                 |   |                     |  |   |      
|1 year            |  | $             | 933   |                 | $ | 1,542               |  | $ | 2,226
|2 years           |  |               | 894   |                 |   | 988                 |  |   | 506  
|3 years           |  |               | 773   |                 |   | 845                 |  |   | 120  
|4 years           |  |               | 7,258 |                 |   | 516                 |  |   |     
|5 years           |  |               |      |                 |   | 322                 |  |   |     
|More than 5 years |  |               |      |                 |   | 2,025               |  |   |     
|                  |  |               |       |                 |   |                     |  |   |      
|                  |  | $             | 9,858 |                 | $ | 6,238               |  | $ | 2,852
|                  |  |               |       |                 |   |                     |  |   |      



At December 31, 2005, SunLink had
contracts with 8 physicians which contain guaranteed minimum gross receipts. SunLink expenses physician guarantees as they are determined to be due to the physician on an accrual basis. Each month the physicians gross patient receipts are
accumulated and the difference between the monthly guarantee and the physicians actual gross receipts for the month is calculated. If the guarantee is greater than the receipts, the difference is accrued as a liability and an expense. The net
guarantee amount is paid to the physician in the



13



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succeeding month. If the physicians monthly receipts exceed the guarantee amount in subsequent months, then the
overage is repaid to SunLink to the extent of any prior monthly guarantee payments and the liability and expense is reduced by the amount of the repayments. SunLink expensed physician guarantees of $466 and $633 for the three months ended
December 31, 2005 and 2004, respectively, and expensed physician guarantees of $885 and $1,314 for the six months ended December 31, 2005 and 2004, respectively. Included in the table above are the maximum obligations SunLink had at
December 31, 2005 for the non-cancelable commitments under physician guarantee contracts. Physician guarantee contracts entered into on or after January 1, 2006, will be accounted for under the provisions of FSP FIN 45-3. See Note 5 
Recent Accounting Pronouncements for discussion of FSP FIN 45-3.



14



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



(dollars in thousands, except per share and admissions data)



Forward-Looking Statements



This Quarterly Report and the documents that are incorporated by reference
in this Quarterly Report contain certain forward-looking statements within the meaning of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all
statements that do not relate solely to historical or current facts and can be identified by the use of words such as may, believe, will, expect, project, estimate,
anticipate, plan or continue. These forward-looking statements are based on current plans and expectations and are subject to a number of risks, uncertainties and other factors which could significantly affect
current plans and expectations and our future financial condition and results. These factors, which could cause actual results, performance and achievements to differ materially from those anticipated, include, but are not limited to:



General Business Conditions



| |  |  | general economic and business conditions in the U.S., both nationwide and in the states in which we operate hospitals;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | the competitive nature of the U.S. community hospital business;
| | - |  | ---------------------------------------------------------------



| |  |  | demographic changes in areas where we operate hospitals;
| | - |  | --------------------------------------------------------



| |  |  | the availability of cash or borrowing to fund working capital, renovations, replacement, expansion and capital improvements at existing hospital facilities and for acquisitions and
replacement hospital facilities;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in accounting principles generally accepted in the U.S.; and,
| | - |  | ---------------------------------------------------------------------



| |  |  | fluctuations in the market value of equity securities including SunLink common shares;
| | - |  | --------------------------------------------------------------------------------------



Operational Factors



| |  |  | the availability of, and our ability to attract and retain, sufficient qualified staff physicians, management, nurses and staff personnel for our hospitals and other business
operations;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | timeliness and amount of reimbursement payments received under government programs;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | restrictions imposed by debt agreements;
| | - |  | ----------------------------------------



| |  |  | the cost and availability of insurance coverage including professional liability (e.g., medical malpractice) and general liability insurance;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the efforts of insurers, healthcare providers and others to contain healthcare costs;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | the impact on hospital services of the treatment of patients in lower acuity healthcare settings, whether with drug therapy or via alternative healthcare services, such as surgery
centers or urgent care centers;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in medical and other technology;
| | - |  | ----------------------------------------



| |  |  | increases in prices of materials and services utilized in our hospital operations;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | increases in wages as a result of inflation or competition for management, nursing and staff positions;
| | - |  | -------------------------------------------------------------------------------------------------------



15



---

| |  |  | increases in the amount and risk of collectibility of accounts receivable , including deductibles and co-pay amounts;
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| |  |  | the cost and management distraction (both at corporate and hospital levels), relating to hostile takeover proposals; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | delays or unanticipated costs with respect to the implementation of a new management information system for our hospitals, including both software and hardware;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



Liabilities, Claims, Obligations and Other
Matters



| |  |  | claims under leases, guarantees and other obligations relating to discontinued operations, including sold facilities, retained or acquired subsidiaries and former subsidiaries;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | potential adverse consequences of known and unknown government investigations;
| | - |  | ------------------------------------------------------------------------------



| |  |  | claims for product and environmental liabilities from continuing and discontinued operations; and,
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | professional, general and other claims which may be asserted against us;
| | - |  | ------------------------------------------------------------------------



Regulation and Governmental Activity



| |  |  | existing and proposed governmental budgetary constraints;
| | - |  | ---------------------------------------------------------



| |  |  | the regulatory environment for our businesses, including state certificate of need laws and regulations, rules and judicial cases relating thereto;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | anticipated adverse changes in the levels and terms of government (including Medicare, Medicaid and other programs) and private reimbursement for SunLinks healthcare services
including the payment arrangements and terms of managed care agreements;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in or failure to comply with Federal, state or local laws and regulations affecting the healthcare industry; and,
| | - |  | -------------------------------------------------------------------------------------------------------------------------



| |  |  | the possible enactment of Federal healthcare reform laws or reform laws in states where we operate hospital facilities (including Medicaid waivers and other reforms);
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



Acquisition Related Matters



| |  |  | the availability and terms of capital to fund additional acquisitions or replacement facilities;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | our ability to integrate acquired hospitals and implement our business strategy; and,
| | - |  | -------------------------------------------------------------------------------------



| |  |  | competition in the market for acquisitions of hospitals and healthcare facilities.
| | - |  | ----------------------------------------------------------------------------------



As a consequence, current plans, anticipated actions and future financial condition and results may differ from those
expressed in any forward-looking statements made by or on behalf of SunLink. You are cautioned not to unduly rely on such forward-looking statements when evaluating the information presented in this Form 10-Q. We have not undertaken any obligation
to publicly update or revise any forward-looking statements.



Risk Factors
Relating to an Investment in SunLink



The following information should be
read in conjunction with the Companys Annual Report on Form 10-K for the year ended June 30, 2005. In addition to other information contained in that



16



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Annual Report, including certain cautionary and forward-looking statements, you should carefully consider the following
factors in evaluating an investment in SunLink:



SunLink has
a limited operating history in the community hospital business and a limited history of profitability.



Prior to February 1, 2001, SunLink operated in different business segments. While SunLink had income from continuing operations of $4,383 for the
fiscal year ended June 30, 2005 and $1,560 for the fiscal year ended June 30, 2003, SunLink had a loss from continuing operations of $1,267 for the fiscal year ended June 30, 2004, a loss from continuing operations of $2,080 for the
fiscal year ended June 30, 2002, a loss of $319 for the three month transitional period ended June 30, 2001, a loss from continuing operations of $881 for the fiscal year ended March 31, 2001, and a loss from continuing operations of
$937 for the fiscal year ended March 31, 2000. SunLink may experience operating losses from continuing operations in the future.



SunLinks success in making selected acquisitions may be restrained by competition to acquire hospitals and by laws relating to hospital
acquisitions.



One element of SunLinks business
strategy is expansion through the selective acquisitions of community hospitals in selected markets. The competition to acquire hospitals in the markets that SunLink targets is significant, and SunLink may not be able to make suitable acquisitions
on terms favorable to it if other healthcare companies, including those with greater financial resources, are competing for the same businesses. In order to make future acquisitions SunLink may be required to incur or assume additional indebtedness.
SunLink may not be able to obtain financing, if necessary, for any acquisitions that it might desire to make or it might be required to borrow at higher rates and on less favorable terms than its competitors.



Many states have enacted or are considering enacting laws affecting sales,
leases or other transactions in which control of not-for-profit hospitals is acquired by for-profit corporations. These laws, in general, include provisions relating to state attorney general approval, advance notification and community involvement.
In addition, state attorneys general in states without specific legislation governing these transactions may exercise authority based upon charitable trust and other existing law. The increased legal and regulatory review of these transactions
involving the change of control of not-for-profit entities may increase the costs required, or limit SunLinks ability, to acquire not-for-profit hospitals.



SunLinks growth strategy depends in part on making successful acquisitions via mergers or otherwise which may
expose SunLink to new liabilities.



As part of its growth
strategy, SunLink will seek further growth through acquisitions of community hospitals, via mergers or otherwise, or to enhance its position in its core areas of operation. This strategy entails risks that could negatively affect SunLinks
results of operations or financial condition. These risks include:



| |  |  | unidentified liabilities of the companies SunLink may acquire or merge with;
| | - |  | ----------------------------------------------------------------------------



| |  |  | the possible inability to successfully integrate and manage acquired operations and personnel;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | the potential failure to achieve the economies of scale or synergies sought; and
| | - |  | --------------------------------------------------------------------------------



| |  |  | the diversion of managements attention away from other ongoing business concerns.
| | - |  | ----------------------------------------------------------------------------------



17



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Acquired businesses may have unknown or contingent liabilities, including liabilities for failure to
comply with healthcare laws and regulations. Although SunLink has policies which require acquired facilities to implement SunLink compliance standards, and generally will seek indemnification from prospective sellers covering these matters, SunLink
may become liable for past activities of acquired businesses.



Significant capital investments may be required to achieve SunLinks operational and growth plans, which may affect SunLinks competitive position, reduce earnings and negatively affect the value of your SunLink common stock.



SunLinks growth plans require significant capital
investments. Significant capital investments are required for on-going and planned capital improvements at existing hospitals and may be required in connection with future capital projects either in connection with existing properties or future
acquired properties. SunLinks ability to make capital investments depends on numerous factors such as the availability of funds from operations and its credit facility and access to additional debt and equity financing. No assurance can be
given that the necessary funds will be available. Moreover, incurrence of additional debt financing, if available, may involve additional restrictive covenants that could negatively affect SunLinks ability to operate its business in the
desired manner, and raising additional equity may be dilutive to shareholders. The failure to obtain funds necessary for the realization of SunLinks growth plans could prevent SunLink from realizing its growth strategy and, in particular,
could force SunLink to forego acquisition opportunities that may arise in the future. This could, in turn, have a negative impact on SunLinks competitive position.



SunLinks success depends on its ability to maintain good relationships with the physicians at its hospitals and, if
SunLink is unable to successfully maintain good relationships with physicians, admissions at SunLink hospitals may decrease and SunLinks operating performance could decline.



Because physicians generally direct the majority of hospital admissions and outpatient services, SunLinks success is,
in part, dependent upon the number and quality of physicians on the medical staffs of its hospitals, the admissions and referrals practices of the physicians at its hospitals and its ability to maintain good relations with its physicians. Physicians
at SunLink hospitals are generally not employees of the hospitals at which they practice and, in many of the markets that SunLink serves, most physicians have admitting privileges at other hospitals in addition to SunLinks hospitals. If
SunLink is unable to successfully maintain good relationships with physicians, admissions at SunLink hospitals may decrease and SunLinks operating performance could decline.



SunLink depends heavily on its senior and local management personnel, and the loss of the services of one or more of
SunLinks key senior management personnel or SunLinks key local management personnel could weaken SunLinks management team and its ability to deliver healthcare services.



SunLink has been, and will continue to be, dependent upon the services and
management experience of its executive officers. If any of SunLinks executive officers were to resign their positions or otherwise be unable to serve, SunLinks management could be weakened and operating results could be adversely
affected. In addition, SunLinks success depends on its ability to attract and retain managers at its hospitals and related facilities, on the ability of hospital-based officers and key employees to manage growth successfully, and on their
ability to attract and retain skilled employees. If SunLink is unable to attract and retain effective local management, SunLinks operating performance could decline.



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SunLinks success depends on its ability to attract and retain qualified healthcare
professionals, and a shortage of qualified healthcare professionals in certain markets could weaken its ability to deliver healthcare services.



In addition to the physicians and management personnel whom SunLink employs, SunLinks operations are dependent on the efforts, ability and
experience of other healthcare professionals, such as nurses, pharmacists and lab technicians. Nurses, pharmacists, lab technicians and other healthcare professionals are generally employees of each individual SunLink hospital. SunLinks
success has been, and will continue to be, influenced by its ability to attract and retain these skilled employees. A shortage of healthcare professionals in certain markets, the loss of some or all of its key employees or the inability to attract
or retain sufficient numbers of qualified healthcare professionals could cause SunLinks operating performance to decline. While SunLink has experienced occasional delays in the hiring of nurses, pharmacists, certain medical technicians and
other healthcare professionals and in obtaining healthcare professionals with the optimum level of experience or training desired, the severe shortages that certain healthcare providers have faced in some markets, particularly in urban areas, to
date have not been present in the community hospital markets served by SunLink.



A significant portion of SunLinks revenue is dependent on Medicare and Medicaid payments, and possible reductions in Medicare or Medicaid payments or the implementation of other measures to reduce
reimbursements may reduce our revenues.



A significant
portion of SunLinks revenues are derived from the Medicare and Medicaid programs, which are highly regulated and subject to frequent and substantial changes. SunLink derived approximately 79% of its patient days and 62% of its net patient
revenues from the Medicare and Medicaid programs for the six months ended December 31, 2005. Previous legislative changes, including those enacted as part of the Balanced Budget Act of 1997, have resulted in, and future legislative changes may
result in, limitations on and reduced levels of payment and reimbursement for a substantial portion of hospital procedures and costs.



Future healthcare legislation or other changes in the administration or interpretation of governmental healthcare programs may have a material adverse
effect on SunLinks business, financial condition, results of operations or prospects. There is a current proposal to eliminate payments for bad debt recovery under current Medicare regulations. Reimbursement under one states Medicaid
indigent care program has been reduced in the current fiscal year and another states Medicaid indigent care program has yet to be finalized for the current fiscal year such that SunLink is unable to predict if its hospitals will qualify for
reimbursement under the program.



Revenue and profitability
may be constrained by future cost containment initiatives undertaken by purchasers of healthcare services if SunLink is unable to contain costs.



SunLink derived approximately 38% of its net patient revenues for the six months ended December 31, 2005 from private payors and other
non-governmental sources who contributed approximately 21% of SunLinks patient days. SunLinks hospitals have been affected by the increasing number of initiatives undertaken during the past several years by all major purchasers of
healthcare, including (in addition to Federal and state governments) insurance companies and employers, to revise payment methodologies and monitor healthcare expenditures in order to contain healthcare costs. As a result of these initiatives,
managed care organizations offering



19



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prepaid and discounted medical services packages represent an increasing portion of SunLinks admissions, resulting
in reduced hospital revenue growth nationwide. In addition, private payers increasingly are attempting to control healthcare costs through direct contracting with hospitals to provide services on a discounted basis, increased utilization review and
greater enrollment in managed care programs such as health maintenance organizations and preferred provider organizations, referred to as PPOs. If SunLink is unable to contain costs through increased operational efficiencies and the trend toward
declining reimbursements and payments continues, the results of its operations and cash flow will be adversely affected.



SunLinks revenues are heavily concentrated in Georgia which makes SunLink particularly sensitive to economic and other changes in the state of
Georgia.



For the fiscal year ended June 30, 2005 and
six months ended December 31, 2005, our three Georgia hospitals generated approximately 49% of revenues for those periods. Accordingly, any change in the current demographic, economic, competitive or regulatory conditions in the state of
Georgia could have a material adverse effect on the business, financial condition, results of operations or prospects of SunLink.



SunLink faces intense competition from other hospitals and healthcare providers which may result in a decline in revenues, profitability or market
share.



Although each of our hospitals operates in
communities in which they are currently the only general, acute care hospital, they do face competition from other hospitals, including larger tertiary care centers. Although these competing hospitals may be as far as 30 to 50 miles away, patients
in these markets may migrate to these competing facilities as a result of local physician referrals, managed care plan incentives or personal choice.



The healthcare business is highly competitive and competition among hospitals and other healthcare providers for patients has intensified in recent years.
Each of our hospitals operates in geographic areas in which they compete with at least one other hospital that provides services comparable to those offered by our hospitals. Some of these competing facilities offer services, including extensive
medical research and medical education programs, which are not offered by SunLinks facilities. Some of the competing hospitals are owned or operated by tax-supported governmental bodies or by private not-for-profit entities supported by
endowments and charitable contributions which can finance capital expenditures on a tax-exempt basis and are exempt from sales, property and income taxes. In some of these markets, SunLinks hospitals also face competition from for-profit
hospital companies which have substantially greater resources as well as other providers such as outpatient surgery and diagnostic centers.



The intense competition from other hospitals and other healthcare providers may result in a decline in SunLinks revenues, profitability or market
share.



SunLink conducts business in a heavily regulated
industry; changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce revenue and profitability.



The healthcare industry is subject to extensive Federal, state and local laws and regulations relating to:



| |  |  | licensure;
| | - |  | ----------



| |  |  | conduct of operations;
| | - |  | ----------------------



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| |  |  | ownership of facilities;
| | - |  | ------------------------



| |  |  | addition of facilities and services;
| | - |  | ------------------------------------



| |  |  | confidentiality, maintenance and security issues associated with medical records;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | billing for services; and
| | - |  | -------------------------



| |  |  | prices for services.
| | - |  | --------------------



These laws and regulations are extremely complex and, in many instances, the industry does not have the benefit of significant regulatory or judicial
interpretation of these laws and regulations, including in particular, Medicare and Medicaid antifraud and abuse amendments, codified in Section 1128B(b) of the Social Security Act and known as the anti-kickback statute. This law
prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent to generate referrals of orders for services or items reimbursable under Medicare, Medicaid and other Federal
healthcare programs.



As authorized by Congress, the United
States Department of Health and Human Services, or HHS, has issued regulations which describe some of the conduct and business relationships immune from prosecution under the anti-kickback statute. The fact that a given business arrangement does not
fall within one of these safe harbor provisions does not render the arrangement illegal. However, business arrangements of healthcare service providers that fail to satisfy the applicable safe harbor criteria risk increased scrutiny by
enforcement authorities.



We have a variety of financial
relationships with physicians who refer patients to our hospitals. We have contracts with physicians providing services under a variety of financial arrangements such as employment contracts and professional service agreements. We also provide
financial incentives, including loans and minimum revenue guarantees, to recruit physicians into the communities served by our hospitals.



The Health Insurance Portability and Accountability Act of 1996 broadened the scope of the fraud and abuse laws to include all healthcare services,
whether or not they are reimbursed under a Federal program. In addition, provisions of the Social Security Act, known as the Stark Act, also prohibit physicians from referring Medicare and Medicaid patients to providers of a broad range of
designated health services in which the physicians or their immediate family members have an ownership interest or certain other financial arrangements.



In addition, SunLinks facilities will continue to remain subject to any state laws that are more restrictive than the regulations issued under the
Health Insurance Portability and Accountability Act of 1996, which vary by state and could impose additional penalties. In recent years, both Federal and state government agencies have announced plans for or implemented heightened and coordinated
civil and criminal enforcement efforts.



Government officials
charged with responsibility for enforcing healthcare laws could assert that SunLink or any of the transactions in which the company or its subsidiaries or their predecessors is or was involved, are in violation of these laws. It is also possible
that these laws ultimately could be interpreted by the courts in a manner that is different from the interpretations made by each company. A determination that either SunLink or its subsidiaries or their predecessors is or was involved in a
transaction that violated these laws, or the public announcement that SunLink or its subsidiaries or their predecessors is being investigated for possible violations of these laws, could have a material adverse effect on SunLinks business,
financial condition, results of operations or prospects and SunLinks business reputation could suffer significantly.



21



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The laws, rules and regulations described above are complex and subject to interpretation. In the event
of a determination that we are in violation of any of these laws, rules or regulations, or if further changes in the regulatory framework occur, our results of operations could be significantly harmed.



SunLinks hospitals and other healthcare facilities are subject to,
and depend on, certificate of need laws which could affect their ability to operate profitably.



All states in which SunLink currently owns hospitals have laws affecting acute care hospital facilities and services known as certificate of
need laws. These states require prior approval for the acquisition of major medical equipment or the purchase, lease, construction, expansion, sale or closure of healthcare facilities, based on determination of need for additional or expanded
facilities or services. The required approval is known generally as a certificate of need or CON. A CON may be required for capital expenditures exceeding a prescribed amount, changes in bed capacity or services, and certain other matters. The
failure to obtain any required CON may impair SunLinks ability to operate profitably, or expand the operations of its healthcare facilities.



In addition, the elimination or modification of CON laws in states in which SunLink owns or in the future may own hospitals could subject its hospitals to
greater competition making it more difficult to operate profitably.



SunLink could be subject to claims related to discontinued operations and hospitals sold by our HealthMont subsidiary prior to its acquisition.



Over the past sixteen years, SunLink has discontinued operations carried on by its former industrial, U.K. leisure marine, life sciences and
engineering, and U.K. child safety segments, as well as our U.K. housewares segment. Prior to our acquisition of our HealthMont subsidiaries, HealthMont had sold two hospitals and it also disposed of one additional hospital as a condition to our
acquisition of HealthMont. We also have disposed of one of our original hospitals. SunLinks reserves relating to discontinued operations represent managements best estimate of possible liability for property, product liability and other
claims for which SunLink may incur liability. These estimates are based on managements judgments using currently available information as well as, in certain instances, consultation with SunLinks insurance carriers and legal counsel.
SunLink historically has purchased insurance policies to reduce certain product liability exposure and anticipates it will continue to purchase such insurance if available at commercially reasonable rates. While estimates have been based on the
evaluation of available information, it is not possible to predict with certainty the ultimate outcome of many contingencies relating to discontinued operations. Furthermore, future events or evaluations could cause us to adjust existing reserves in
connection with its operations. SunLink intends to adjust its estimates of required reserves from time to time as additional information is developed and evaluated.



We are subject to potential claims for professional liability, including claims based on the acts or omissions of third
parties, which claims may not be covered by insurance.



We
are subject to potential claims for professional liability (medical malpractice), both in connection with our current operations, as well as acquired operations. To cover these claims, we maintain professional malpractice liability insurance and
general liability insurance in amounts



22



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that we believe are sufficient for our operations, although some claims may exceed the scope or amount of the coverage in
effect. The assertion of a significant number of claims, either within our self-insured retention (deductible) or individually or in the aggregate in excess of available insurance, could have a material adverse effect on our results of operations or
financial condition. Premiums for professional liability insurance have increased substantially in recent times and we can not assure you that professional liability insurance will continue to be available on terms acceptable to us, if at all. The
operations of our hospitals also depend on the professional services of physicians and other trained healthcare providers and technicians in the conduct of their respective operations, including independent laboratories and physicians rendering
diagnostic and medical services. There can be no assurance that any legal action stemming from the act or omission of a third party provider of healthcare services, would not be brought against one of our hospitals or SunLink, resulting in
significant legal expenses in order to defend against such legal action or to obtain a financial contribution from the third-party whose acts or omissions occasioned the legal action.



SunLink may issue additional equity in the future which could dilute the value of shares of existing shareholders.



SunLinks working capital is limited to cash generated
from operations and borrowings available under our $30,000 credit facility (of which approximately $20,000 was available to borrow at December 31, 2005) and its additional debt capacity is limited. Management and the board of directors of
SunLink periodically have discussed the need to raise equity in the future and periodically have considered certain transactions which might be available to SunLink to raise equity. However, SunLink has not engaged any underwriter or placement agent
with respect to any potential equity offering, nor has SunLinks management made any specific proposal or recommendation to the SunLink board of directors with respect to the type of securities to be offered or of the price at which any
securities might be offered. Such transactions might include one or more of the sale of common shares to outsiders, the offer to existing shareholders of the right to acquire additional shares, or the reduction in the exercise price of
SunLinks outstanding warrants to a level and on terms that would be expected to result in their immediate exercise. While the board of directors has not decided to effect any of these transactions at this time, it may do so in the future. Any
of these transactions could result in dilution in the value of existing shares.



Forward-looking statements in this quarterly report may prove inaccurate.



This document contains forward-looking statements about SunLink that are not historical facts but, rather, are statements about future expectations.
Forward-looking statements in this document are based on managements current views and assumptions and may be influenced by factors that could cause actual results, performance or events to be materially different from those projected. These
forward-looking statements are subject to numerous risks and uncertainties. Important factors, some of which are beyond the control of SunLink, could cause actual results, performance or events to differ materially from those in the forward-looking
statements. These factors include those described above under Risk Factors and elsewhere in this report under Forward-Looking Statements.



Corporate Business Strategy



Since 2001, our business strategy has focused on the acquisition and operation of community hospitals in the United States. On February 1, 2001,
SunLink purchased five community hospitals, leasehold rights for a sixth existing hospital and the related businesses of all six hospitals for approximately $26,500. In October 2003, we acquired two additional hospitals



23



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through our acquisition of HealthMont, Inc. In June 2004, we sold our Mountainside Medical Center, a 35-bed hospital
located in Jasper, GA for approximately $40,000. Through our subsidiaries, we currently operate a total of seven community hospitals in four states. Currently six of the hospitals are owned and one is leased.



Our primary operational strategy is to improve the profitability of our
hospitals by reducing out-migration of patients, recruiting physicians, expanding services and implementing and maintaining effective cost controls. Our efforts are focused on internal growth. However, we actively seek to supplement internal growth
through acquisitions. Our acquisition strategy is to selectively acquire community hospitals with net revenues of approximately $10,000 or more which are (1) the sole or primary hospital in market areas with a population of greater than 15,000
or (2) a principal healthcare provider with substantial market share in communities with a population of 50,000 to 150,000. We believe all of our seven existing hospitals meet at least one of these two market area criteria. The Company
considers recent prices paid by others for certain hospital acquisitions to be higher than we would be willing to pay but believes there may be opportunities for acquisitions of individual hospitals (particularly not-for-profit hospitals) in the
future due to, among other things, negative trends in certain government reimbursement programs and other factors. From time to time we may consider hospitals for disposition if we determine their operating results or potential growth no longer meet
our strategic objectives.



Critical Accounting Policies and Estimates



In January 2002, the SEC issued disclosure guidance
for critical accounting policies. The SEC defines critical accounting policies as those that require application of managements most difficult, subjective or complex judgments, often as a result of the need to make
estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.



The following is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular
transaction is specifically dictated by accounting principles generally accepted in the United States of America, with little or no need for managements judgment in their application. There are also areas in which managements judgment in
selecting an available alternative would not produce a materially different result.



We have identified the following as accounting policies critical to us:



Management Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Some of the more significant estimates made by management involve reserves for adjustments to net patient service revenues, evaluation of the recoverability of assets, including accounts receivable,
and the assessment of litigation and contingencies, including income taxes and related tax asset valuation allowances, all as discussed in more detail in the notes to the consolidated financial statements included in the SunLink Annual Report on
Form 10-K for the fiscal year ended June 30, 2005 filed with the SEC on September 16, 2005. Actual results could differ materially from these estimates.



Net Patient Service Revenues We have agreements with third-party payors that provide for payments at amounts different from established
charges. Payment arrangements vary and include prospectively determined rates per discharge, reimbursed costs, discounted charges and per diem payments. Our patient service revenues are reported as services are rendered at the estimated net
realizable amounts from patients, third-party payors and others. Estimated net realizable amounts are estimated based upon contracts with third-party payors, published reimbursement rates and historical reimbursement percentages pertaining to each
payor type. Estimated reductions in revenues to reflect agreements with third-party payors and estimated retroactive adjustments



24



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under such reimbursement agreements are accrued during the period the related services are rendered and are adjusted in
future periods as interim and final settlements are determined. Significant changes in reimbursement levels for services under government and private programs could significantly impact the estimates used to accrue such revenue deductions. At
December 31, 2005, there were no known material claims or disputes with third-party payors.



Allowance for Doubtful Accounts Substantially all of SunLinks receivables result from providing healthcare services to patients.
Accounts receivable are reduced by an allowance for doubtful accounts estimated to become uncollectible in the future. The Company calculates an allowance percentage based generally upon its historical collection experience for each type of payor.
The allowance amount is computed by applying allowance percentages to receivable amounts included in specific payor categories. Significant changes in reimbursement levels for services under government and private programs could significantly impact
the estimates used to determine the allowance for doubtful accounts. Accounts receivable are written off after all collection efforts have failed, normally within six months of billing.



Risk Management We are exposed to various risks of loss from medical malpractice and other claims and
casualties; theft of, damage to, and destruction of assets; business interruption; errors and omissions; employee injuries and illnesses; natural disasters (including earthquakes); and employee health, dental and accident benefits. Commercial
insurance coverage is purchased for a portion of claims arising from such matters. When, in our judgment, claims are sufficiently identified, a liability is accrued for estimated costs and losses under such claims.



In connection with the acquisition of the original six hospitals, we assumed
responsibility for professional liability claims reported after the February 1, 2001 acquisition date and the previous owner retained responsibility for all known and filed claims prior to the acquisition date. We purchased claims-made
commercial insurance for acts prior to and after the acquisition date. The recorded liability for professional liability risks includes an estimate of the liability for claims incurred prior to February 1, 2001, but reported after
February 1, 2001, and for claims incurred after February 1, 2001. These amounts are based on actuarially determined amounts. On June 1, 2004 we sold Mountainside Medical Center, one of our initial six hospitals, but retained all
liabilities and obligations arising from Mountainsides operations prior to its sale and purchased a 7-year, claims made, extended discovery period (tail) policy for professional liability.



By virtue of our acquisition of HealthMont and its two hospitals, we assumed
responsibility for all professional liability claims for which HealthMont was, or is, liable. HealthMont had purchased claims-made commercial insurance for claims made prior to our acquisition and we have purchased claims-made commercial insurance
for claims made after the acquisition. SunLink secured a claims made, extended discovery period (tail) policy with respect to HealthMonts existing directors, officers and employment practices liability insurance policy for a term through
August 31, 2005 because SunLink assumed responsibility for existing general and professional liability claims and claims reported after the acquisition date. The recorded liability for professional liability risks includes an estimate of
liability for claims assumed at the acquisition and for claims incurred after the acquisition. These amounts are based on actuarially determined amounts.



We self-insure for workers compensation risks and prior to October 1, 2005, self-insured for employee health risks. On October 1, 2005,
SunLink entered into a fully-insured insurance plan for employee health risks. The estimated liability for workers compensation and employee health risks includes estimates of the ultimate costs for both reported claims and claims incurred but
not reported. We accrue an estimate of losses resulting from workers compensation, employee health and professional liability claims to the extent they are not covered by insurance. These accruals are estimated quarterly based upon
managements review of claims reported and historical loss data.



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We record a liability pertaining to pending litigation if it is probable a loss has been incurred and
accrue the most likely amount of loss based on the information available. If no amount within the range of losses estimated from the information available is more likely than any other amount in the range of loss, the minimum amount in the range of
loss is accrued. Because of uncertainties surrounding the nature of litigation and the ultimate liability to us, if any, we revise our estimated losses as additional facts become known.



Goodwill and Other IntangiblesSunLink accounts for goodwill and intangible assets from business
combinations in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. Goodwill represents the cost of acquired businesses in excess of fair value of identifiable
tangible and intangible net assets purchased. SFAS No. 142 recognizes that goodwill has an indefinite life and is not subject to periodic amortization. However, goodwill is tested at least annually for impairment, using a fair value
methodology, in lieu of amortization. Definite-lived intangible assets, such as certificates of need, are amortized over their estimated useful lives, generally for periods ranging from 23 to 30 years. SunLink continually evaluates the
reasonableness of the useful lives of intangible assets and they are tested for impairment as conditions warrant according to SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets.



Income Taxes We account for income taxes in accordance with
SFAS No. 109, Accounting for Income Taxes.SFAS No. 109 requires an asset and liability approach and the recognition of deferred tax assets and liabilities for expected future tax consequences. SFAS No. 109 generally requires
consideration of all expected future events other than proposed enactments of changes in the income tax law or rates.



Stock-Based Compensation -Effective July 1, 2005, the Company adopted SFAS No. 123 (R) Share-Based Paymentwhich
requires measuring compensation cost for share options using a fair-value-based method for employee stock options issued after and for non-vested employee stock options outstanding at the adoption date.



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Financial Summary



The results of continuing operations shown in the financial summary below are for our sole business segment, U.S. community hospitals, which is
composed of five SunLink facilities acquired February 1, 2001 (SHL Facilities) and two HealthMont facilities acquired October 3, 2003 (HealthMont Facilities).



|                                                        |  |                                 |         |   |                               |   |         |          |  |       |      |  |   |         |   |  |          |         |   |  |       |   
|------------------------------------------------------- |  | ------------------------------- | ------- | - | ----------------------------- | - | ------- | -------- |  | ----- | ---- |  | - | ------- | - |  | -------- | ------- | - |  | ----- | --
|                                                        |  | THREE MONTHS ENDED December 31, |         |   | SIX MONTHS ENDED December 31, |  
|                                                        |  | 2005                            |         |   | 2004                          |   |         | % Change |  |       | 2005 |  |   | 2004    |   |  | % Change |        
|Net revenues                                            |  | $                               | 32,242  |   |                               | $ | 31,291  |          |  | 3.0   | %    |  | $ | 66,141  |   |  | $        | 61,748  |   |  | 7.1   | % 
|Cost of patient service revenues                        |  |                                 | (30,288 | ) |                               |   | (29,963 | )        |  | 1.1   | %    |  |   | (62,242 | ) |  |          | (59,702 | ) |  | 4.3   | % 
|                                                        |  |                                 |         |   |                               |   |         |          |  |       |      |  |   |         |   |  |          |         |   |  |       |   
|Operating profit                                        |  |                                 | 1,954   |   |                               |   | 1,328   |          |  | 47.1  | %    |  |   | 3,899   |   |  |          | 2,046   |   |  | 90.6  | % 
|                                                        |  |                                 |         |   |                               |  
|Loss on early debt repayment                            |  |                                 |        |   |                               |   | (384    | )        |  | N/A   |      |  |   |        |   |  |          | (384    | ) |  | N/A   |   
|Interest expense                                        |  |                                 | (286    | ) |                               |   | (276    | )        |  | 3.6   | %    |  |   | (561    | ) |  |          | (596    | ) |  | (5.9  | )%
|Interest income                                         |  |                                 | 19      |   |                               |   | 12      |          |  | 58.3  | %    |  |   | 39      |   |  |          | 25      |   |  | 56.0  | % 
|                                                        |  |                                 |         |   |                               |   |         |          |  |       |      |  |   |         |   |  |          |         |   |  |       |   
|Earnings from Continuing Operations before Income Taxes |  | $                               | 1,687   |   |                               | $ | 680     |          |  | 148.1 | %    |  | $ | 3,377   |   |  | $        | 1,091   |   |  | 209.5 | % 
|                                                        |  |                                 |         |   |                               |   |         |          |  |       |      |  |   |         |   |  |          |         |   |  |       |   
|Admissions                                              |  |                                 | 2,408   |   |                               |   | 2,479   |          |  | (2.9  | )%   |  |   | 4,992   |   |  |          | 4,987   |   |  | 0.1   | % 
|                                                        |  |                                 |         |   |                               |   |         |          |  |       |      |  |   |         |   |  |          |         |   |  |       |   
|Equivalent Admissions                                   |  |                                 | 6,086   |   |                               |   | 6,019   |          |  | 1.1   | %    |  |   | 12,668  |   |  |          | 12,324  |   |  | 2.8   | % 
|                                                        |  |                                 |         |   |                               |   |         |          |  |       |      |  |   |         |   |  |          |         |   |  |       |   
|Surgeries                                               |  |                                 | 1,312   |   |                               |   | 1,255   |          |  | 4.5   | %    |  |   | 2,532   |   |  |          | 2,540   |   |  | (0.3  | )%
|                                                        |  |                                 |         |   |                               |   |         |          |  |       |      |  |   |         |   |  |          |         |   |  |       |   
|Revenue per Equivalent Admission                        |  | $                               | 5,298   |   |                               | $ | 5,199   |          |  | 1.9   | %    |  | $ | 5,221   |   |  | $        | 5,010   |   |  | 4.2   | % 
|                                                        |  |                                 |         |   |                               |   |         |          |  |       |      |  |   |         |   |  |          |         |   |  |       |   



Equivalent
admissions Equivalent admissions is used by management (and certain investors) as a general measure of combined inpatient and outpatient volume. Equivalent admissions are computed by multiplying admissions (inpatient volume) by the sum of
gross inpatient revenues and gross outpatient revenues and dividing the result by gross inpatient revenues. The equivalent admissions computation is intended to relate outpatient revenues to the volume measure (admissions) used to measure inpatient
volume to result in a general approximation of combined inpatient and outpatient volume (equivalent admissions).



Results of Operations



Net revenues for the quarter ended December 31, 2005 were $32,242 with a total of 6,086 equivalent admissions and revenues per equivalent admission
of $5,298 compared to net revenues of $31,291, a total of 6,019 equivalent admissions and revenues per equivalent admission of $5,199 for the quarter ended December 31, 2004. The 3.0% increase in net revenues for the quarter ended
December 31, 2005 was due to a 1.1% increase in equivalent admissions, a 4.5% increase in surgeries and a 1.9% increase in revenue per equivalent admission. Net outpatient service revenues increased $1,669, a 12.6% increase from last year to
$14,904 for the three months ended December 31, 2005 and increased to 46.2% of net revenues from 42.3% last year. Net revenue for the three months ended December 31, 2005 and 2004 included $269 and $774, respectively, from state indigent
care programs. The decrease is attributable to reduced Medicaid payments in two states. Net revenues for the six months ended December 31, 2005 were $66,141 with a total of 12,668 equivalent admissions and revenues per equivalent admission of
$5,221 compared to net revenues of $61,748, a total of 12,324 equivalent admissions and revenues per equivalent admission of $5,010 for the six months ended December 31, 2004. The 7.1% increase



27



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in net revenues for the six months ended December 31, 2005 was due to a 2.8% increase in equivalent admissions, and
a 4.2% increase in revenue per equivalent admission. Net outpatient service revenues increased $4,037, a 15.4% increase from last year, to $30,264 for the six months ended December 31, 2005 and increased to 45.8% of net revenues from 42.5% last
year. Net revenue for the six months ended December 31, 2005 and 2004 included $405 and $1,435, respectively, from state indigent care programs.



Recruitment of new doctors and spending for capital improvements have contributed greatly to the increase in net revenues. We added six net new doctors
during the year ended June 30, 2005 and eight net new doctors during the six months ended December 31, 2005. During the six months ended December 31, 2005, SunLink spent $885 on physician guarantees and recruiting expenses compared to
$1,314 for the same period last year. We also have expended approximately $7,139 for capital expenditures to upgrade services and facilities since July 1, 2004. We believe the upgraded services and facilities and the new doctors contributed to
the increase in net revenues and equivalent admissions for the three and six months ended December 31, 2005 compared to the same periods of the prior year. We continue to seek increased patient volume by attracting additional physicians to our
hospitals, further upgrading the services offered by the hospitals and improving the hospitals physical facilities.



The following table sets forth the percentage of net patient revenues from major payor sources for the Companys hospitals during the periods
indicated:



|                             |  |                                |   |  |                              |   |  |       |   |  |       |  
|---------------------------- |  | ------------------------------ | - |  | ---------------------------- | - |  | ----- | - |  | ----- | -
|                             |  | Three Months EndedDecember 31, |   |  | Six Months EndedDecember 31, |  
|                             |  | 2005                           |   |  | 2004                         |   |  | 2005  |   |  | 2004  |  
|Source                       |  |                                |   |  |                              |   |  |       |   |  |       |  
|Medicare                     |  | 45.3                           | % |  | 46.0                         | % |  | 44.9  | % |  | 45.6  | %
|Medicaid                     |  | 16.3                           | % |  | 17.9                         | % |  | 16.5  | % |  | 17.8  | %
|Self pay                     |  | 7.7                            | % |  | 7.3                          | % |  | 8.1   | % |  | 7.9   | %
|Commercial Insurance & Other |  | 30.7                           | % |  | 28.8                         | % |  | 30.5  | % |  | 28.7  | %
|                             |  |                                |   |  |                              |   |  |       |   |  |       |  
|                             |  | 100.0                          | % |  | 100.0                        | % |  | 100.0 | % |  | 100.0 | %
|                             |  |                                |   |  |                              |   |  |       |   |  |       |  



During the three and
six months ended December 31, 2005, we have experienced a decrease in Medicare and Medicaid as a percentage of net revenues with an increase in Commercial Insurance and other revenues. In each case, the changes were due primarily to increased
managed care patients. In absolute dollars, Medicare net revenues increased in the three months ended December 31, 2005, compared to the prior year, but the increases were at lower rates than the overall 3.0% increase in net revenues.



28



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Cost of patient service revenues, including depreciation, was $30,288 and $29,963 for the three months
ended December 31, 2005 and 2004, respectively and $62,242 and $59,702 for the six months ended December 31, 2005 and 2004, respectively.



|                             |  |                                                       |   |  |                              |   |  |      |   |  |      |  
|---------------------------- |  | ----------------------------------------------------- | - |  | ---------------------------- | - |  | ---- | - |  | ---- | -
|                             |  | Cost of Patient Service Revenues As % of Net Revenues |  
|                             |  | Three Months EndedDecember 31,                        |   |  | Six Months EndedDecember 31, |  
|                             |  | 2005                                                  |   |  | 2004                         |   |  | 2005 |   |  | 2004 |  
|Salaries, wages and benefits |  | 50.2                                                  | % |  | 48.2                         | % |  | 48.9 | % |  | 48.1 | %
|Provision for bad debts      |  | 10.9                                                  | % |  | 10.4                         | % |  | 11.2 | % |  | 10.2 | %
|Supplies                     |  | 10.9                                                  | % |  | 11.0                         | % |  | 10.8 | % |  | 11.2 | %
|Purchased services           |  | 6.5                                                   | % |  | 5.9                          | % |  | 6.4  | % |  | 5.8  | %
|Other operating expenses     |  | 11.2                                                  | % |  | 16.3                         | % |  | 12.6 | % |  | 16.8 | %
|Rent and lease expense       |  | 1.9                                                   | % |  | 2.0                          | % |  | 1.8  | % |  | 2.6  | %



Salaries, wages and
benefits expense increased as a percentage of net revenues for the three and six months ended December 31, 2005 due to higher contract labor expense and $209 of expense in the six months ended December 31, 2005 for stock option
compensation expense as a result of the required adoption of FAS 123(R). Provision for bad debt expense increased as a percent of net revenue in the current year due to increases of approximately $271 and $587 for the three and six month periods,
respectively, of self-pay revenues, increases in charges for services rendered that were not collected and overall decreased collections as a percentage of revenues due to greater market penetration in the geographic areas served by the
Companys hospitals. Other operating expenses decreased as a percentage of net revenues in the current year due to decreased insurance expense. This decrease resulted from lower expense due to lower actuarially-determined liability for
professional liability risks. Purchased services increased as a percent of net revenue due to increased usage of outside services such as radiology, nuclear medicine and MRI.



Depreciation and amortization expense increased $195 and $329 for the three and six months ended December 31, 2005
compared to the comparable prior year periods. The increase in the current year was due primarily to the approximately $7,139 of capital expenditures in the past 18 months.



Operating profit for the three months ended December 31, 2005 was $1,954 or 6.1% of net revenues compared to $1,328 or
4.2% of net revenues for the three months ended December 31, 2004. The increase in operating profit as a percentage of net revenues was primarily attributable to higher net revenues. The increase in operating profit for the current years
three months is attributable to the increased net revenues in the current year. Interest expense was $286 and $276 for the three months ended December 31, 2005 and 2004, respectively. The slightly higher interest expense in the current year was
due to higher interest rates related to the SunLink Term Loan in the current year. Interest expense was $561 and $596 for the six months ended December 31, 2005 and 2004, respectively. The decrease in interest expense for the six months period
this year was due to lower interest rates related to the SunLink Term Loan that was entered into in October 2004 compared to higher interest rate debt repaid by SunLink in October 2004.



Income tax expense of $770 ($774 federal expense and $4 state benefit) and $28 (all state taxes) was recorded for the three
months ended December 31, 2005 and 2004, respectively. The $774 federal tax expense for the three months ended December 31, 2005 included $742 deferred income tax expense. The effective income tax rate of 45.6% for the quarter ended
December 31, 2005 increased substantially from the 4.1% for the quarter ended December 31, 2004 due to much lower net operating loss carryforwards available in the current year. Income tax expense of $1,376 ($1,229 federal and $147 state
tax expense) and $116 (all state taxes) was recorded for the six months ended December 31, 2005 and 2004,



29



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respectively. The $1,229 federal tax expense for the six months ended December 31, 2005 included $372 deferred
income tax expense. We had an estimated net operating loss carry-forward for federal income tax purposes of approximately $8,200 at December 31, 2005. Use of this net operating loss carry-forward is subject to the limitations of the provisions
of Internal Revenue Code Section 382. As a result, not all of the net operating loss carry-forward is available to offset federal taxable income in the current year. At December 31, 2005, we have provided a partial valuation allowance of
the deferred tax so that the net domestic tax asset was $838. Based upon managements assessment that it was more likely than not that a portion of its domestic deferred tax asset (primarily its domestic net operating losses subject to
limitation) would not be recovered, the Company established a valuation allowance for the portion of the domestic tax asset which may not be utilized. The Company has provided a valuation allowance for the entire amount of the foreign tax asset as
it is more likely than not that none of the foreign deferred tax assets will be realized through future taxable income or implementation of tax planning strategies.



In October 2004, the Company repaid early debt totaling approximately $7,700. The early repayment resulted in a loss on
early repayment of debt of $384. This loss was composed of $263 of unamortized prepaid debt costs related to the repaid debt instruments and a $121 penalty related to the early repayment of a revolving loan.



Earnings from continuing operations were $917 ($0.12 per fully diluted share)
in the quarter ended December 31, 2005 compared to earnings from continuing operations of $652 ($0.08 per fully diluted share) in the comparable quarter last year. Increased operating profit and the non-recurrence of the loss on early repayment
of debt in the current years quarter, offset partially by increased income tax expense, resulted in the increased earnings from continuing operations in the current year. Earnings from continuing operations were $2,001 ($0.26 per fully diluted
share) in the six months ended December 31, 2005 compared to earnings from continued operations of $975 ($0.13 per fully diluted share) for the six months ended December 31, 2004. Net earnings of $902 ($0.11 per fully diluted share) in the
quarter ended December 31, 2005 compared to net earnings of $689 ($0.09 per fully diluted share) in the quarter ended December 31, 2004. Net earnings of $2,005 ($0.26 per fully diluted share) in the six months ended December 31, 2005
compared to net earnings of $998 ($0.13 per fully diluted share) in the six months ended December 31, 2004.



Earnings before income taxes, interest, depreciation and amortization



Earnings before income taxes, interest, depreciation and amortization (Ebitda) represent the sum of income
before income taxes, interest, depreciation and amortization. We understand that certain industry analysts and investors generally consider Ebitda to be one measure of the financial performance of a company, and it is presented to assist analysts
and investors in analyzing the operating performance of a company and its ability to service debt. We believe increased Ebitda is an indicator of improved ability to service existing debt and to satisfy capital requirements. Ebitda, however, is not
a measure of financial performance under accounting principles generally accepted in the United States of America and should not be considered an alternative to net income as a measure of operating performance or to cash liquidity. Because Ebitda is
not a measure determined in accordance with accounting principles generally accepted in the United States of America and is thus susceptible to varying calculations, Ebitda, as presented, may not be comparable to other similarly titled measures of
other corporations.



30



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Operating profit for the three and six months ended December 31, 2005 and 2004, respectively, was as
follows:



|                                           |  |                                 |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------ |  | ------------------------------- | ------ | - | ---------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                           |  | Three Months Ended December 31, |        |   | Six Months EndedDecember 31, |  
|                                           |  | 2005                            |        |   | 2004                         |   |        | 2005 |  |   | 2004   |  
|SHL Facilities Ebitda (5 hospitals)        |  | $                               | 3,194  |   |                              | $ | 2,802  |      |  | $ | 6,699  |   |  | $ | 5,046  |  
|HealthMont Facilities Ebitda (2 hospitals) |  |                                 | 1,009  |   |                              |   | 211    |      |  |   | 1,292  |   |  |   | 299    |  
|Corporate overhead costs                   |  |                                 | (1,465 | ) |                              |   | (1,096 | )    |  |   | (2,540 | ) |  |   | (2,076 | )
|Depreciation and amortization              |  |                                 | (784   | ) |                              |   | (589   | )    |  |   | (1,552 | ) |  |   | (1,223 | )
|                                           |  |                                 |        |   |                              |   |        |      |  |   |        |   |  |   |        |  
|Operating profit                           |  | $                               | 1,954  |   |                              | $ | 1,328  |      |  | $ | 3,899  |   |  | $ | 2,046  |  
|                                           |  |                                 |        |   |                              |   |        |      |  |   |        |   |  |   |        |  



Liquidity and Capital Resources



We generated $1,775 of cash in operating activities
during the six months ended December 31, 2005 compared to $2,831 of cash used during the comparable period last year. The cash generated from operations in the current year resulted from the $2,005 net earnings for the period, $1,552 of
depreciation and amortization for the period, somewhat offset by approximately $1,782 of cash used by increased net assets. Cash paid for taxes was $2,880 for the six months ended December 31, 2005. Cash was generated from operations from
decreased receivables and increased third-party payor settlements, offset by decreased accounts payable and other accrued expenses. The cash usage in the prior years six months resulted from approximately $3,873 of income tax payments related
to the gain on the sale of Mountainside in June 2004.



On
October 15, 2004, SunLink entered into a $30,000 five-year senior secured credit facility comprised of a revolving line of credit of up to $15,000 with an interest rate at LIBOR plus 2.91%, a $10,000 term loan with an interest rate at LIBOR
plus 3.91% and a $5,000 term loan facility with an interest rate at LIBOR plus 3.91% (the SunLink Credit Facility). Only the $10,000 term loan has been drawn, of which $9,222 was outstanding at December 31, 2005. The proceeds were
used to repay $7,700 of HealthMont debt which was payable on August 31, 2005. SunLink is using the remaining funds from the initial draw and expects to use the funds available from the revolving line of credit for hospital capital projects,
equipment purchases and working capital needs. The $10,000 term loan and draws under the $5,000 term loan are repayable based on a 15-year amortization from the date of draw with final balloon payments due at the end of the five-year maturity of the
credit facility. The total availability under all components of the credit facility is keyed to the level of SunLinks earnings, which would have provided for current total borrowing capacity at December 31, 2005 of approximately $29,222.
Borrowing under the $5,000 term loan may be used, subject to satisfaction of certain covenants, to satisfy certain specified claims and obligations, to fund acquisitions (or a portion thereof) or to reacquire the Companys securities. Costs and
fees related to execution of the credit facility were $916. The SunLink Credit Facility is collateralized by a first priority security interest in all assets and properties, real and personal, of the Company and its consolidated domestic
subsidiaries, including a pledge of all of the equity interests in such subsidiaries.



If SunLink or its applicable subsidiaries experience a material adverse change in their business, assets, financial condition, management or operations, or if the value of the collateral securing the SunLink Credit
Facility decreases, we may be unable to draw on such credit facility.



We expended $3,110 for capital improvements at our hospitals during the six months ended December 31, 2005. We believe attractive and up-to-date physical facilities assist in recruiting quality staff and physicians, as well as
attracting patients. Subject to the availability of internally generated funds and other financing, we currently expect to expend approximately $1,900 for capital expenditures (including the capitalized cost of the new management information system)
during the remaining six months of the fiscal year ending June 30, 2006.



31



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SunLinks strategy is to focus its efforts on internal growth of its seven hospitals supplemented by
growth from selected acquisitions. Subject to the availability of debt and/or equity capital, SunLinks internal growth may include replacement or expansion of its existing hospitals involving substantial capital expenditures as well as the
expenditure of significant amounts of capital for selected hospital acquisitions.



We believe we have adequate financing and liquidity to support our current level of operations through the next twelve months. Our primary sources of liquidity are cash generated from continuing operations and
availability under the SunLink Credit Facility. The total availability of credit under all components of the SunLink Credit Facility is keyed to the level of SunLinks earnings, which, based upon the Companys estimates, would provide for
current borrowing capacity, before any draws, of approximately $29,222 at December 31, 2005, of which $9,222 was outstanding under a term loan. The current remaining availability of approximately $20,000 could be adversely affected by, among
other things, lower earnings due to lower demand for our services by patients, change in patient mix and changes in terms and levels of government and private reimbursement for services. Cash generated from operations could be adversely affected by,
among other things, lower patient demand for our services, higher operating costs (including, but not limited to, salaries, wages and benefits, provisions for bad debts, general liability and other insurance costs, cost of pharmaceutical drugs and
other operating expenses) or by changes in terms and levels of government and private reimbursement for services, and the regulatory environment of the community hospital segment.



Contractual Obligations, Commitments and Contingencies



Contractual obligations, commitments and contingencies related to long-term debt, non-cancelable operating leases and
physician guarantees from continuing operations at December 31, 2005 were as follows:



|                  |  |               |       |                 |   |                     |  |   |      
|----------------- |  | ------------- | ----- | --------------- | - | ------------------- |  | - | -----
|                  |  | Long-TermDebt |       | OperatingLeases |   | PhysicianGuarantees
|Payments due in:  |  |               |       |                 |   |                     |  |   |      
|1 year            |  | $             | 933   |                 | $ | 1,542               |  | $ | 2,226
|2 years           |  |               | 894   |                 |   | 988                 |  |   | 506  
|3 years           |  |               | 773   |                 |   | 845                 |  |   | 120  
|4 years           |  |               | 7,258 |                 |   | 516                 |  |   |     
|5 years           |  |               |      |                 |   | 322                 |  |   |     
|More than 5 years |  |               |      |                 |   | 2,025               |  |   |     
|                  |  |               |       |                 |   |                     |  |   |      
|                  |  | $             | 9,858 |                 | $ | 6,238               |  | $ | 2,852
|                  |  |               |       |                 |   |                     |  |   |      



At December 31, 2005, SunLink had
contracts with 8 physicians which contain guaranteed minimum gross receipts. SunLink expenses physician guarantees as they are determined to be due to the physician on an accrual basis. Each month the physicians gross patient receipts are
accumulated and the difference between the monthly guarantee and the physicians actual gross receipts for the month is calculated. If the guarantee is greater than the receipts, the difference is accrued as a liability and an expense. The net
guarantee amount is paid to the physician in the succeeding month. If the physicians monthly receipts exceed the guarantee amount in subsequent months, then the overage is repaid to SunLink to the extent of any prior monthly guarantee payments
and the liability and expense is reduced by the amount of the repayments. SunLink expensed physician guarantees of $466 and $633 for the three months ended December 31, 2005 and 2004, respectively, and expensed physician guarantees of $885 and
$1,314 for the six months ended December 31, 2005 and 2004, respectively. Included in the table above are the maximum obligations SunLink had at December 31, 2005 for the non-cancelable commitments under



32



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physician guarantee contracts. Physician guarantee contracts entered into on or after January 1, 2006, will be
accounted for under the provisions of FSP FIN 45-3. See the Recent Accounting Pronouncements section of this Item 2 for discussion of FSP FIN 45-3.



At December 31, 2005, we had outstanding long-term debt of $9,858 of which $9,222 was incurred in connection with the
SunLink Credit Facility and $636 was related to capital leases.



SunLink currently utilizes three different management information systems at our seven hospitals. Five hospitals utilize comprehensive systems designed for larger hospitals and two hospitals utilize a system designed for smaller hospitals.
We are converting our hospitals to a single management information system with implementation scheduled to be completed before expiration of our existing software lease and support agreements which have unexpired terms of up to one year. In June
2005, SunLink entered into a license and support agreement with a management information system company for the single management information system with an estimated cost of $2,800 for software, installation, training and support. In July 2005,
SunLink entered into a capital lease for computers and other hardware for the new system with a total commitment of approximately $273. The total cost of the software licenses, hardware, installation and training for the new management information
system is estimated to be $3,200, approximately $2,500 of which is expected to be capitalized and amortized over the estimated useful life of the new system, which is 4 years for hardware and 7 years for the licenses and installation. This
conversion began in the fiscal quarter ending September 30, 2005 and is expected to be completed by September 30, 2006.



Discontinued Operations



SunLink sold its former U.K. subsidiary, Beldray Limited (Beldray), to two of its managers in October 2001. Beldray has since entered
into administrative receivership and is under the administration of its primary lender. SunLink believes Beldray ceased to operate in October 2004.



As previously disclosed in the notes to our financial statements, KRUG International U.K. Ltd. (KRUG UK), an inactive U.K. subsidiary
of SunLink, entered into a guarantee (the Beldray Guarantee), at a time when it owned Beldray, a U.K. manufacturing business. The Beldray Guarantee covers Beldrays obligations under a lease of a portion of Beldrays
manufacturing location. In October 2004, KRUG UK received correspondence from the landlord of such facility stating that the rent payment of 94,000 British pounds ($181) for the fourth quarter of 2004 had not been paid by Beldray and requesting
payment of such amount pursuant to the Beldray Guarantee. In January 2005, KRUG UK received further correspondence from the landlord demanding two quarterly rent payments totaling 188,000 British pounds ($362) under the Beldray Guarantee. In January
2005, the landlord filed a petition in the High Court of Justice Chancery Division to wind up KRUG UK under the provisions of the Insolvency Act of 1986 and KRUG UK was placed into involuntary liquidation by the High Court in February 2005.



SunLinks non-current liability reserves for discontinued
operations at December 31, 2005, included $1,105 for a portion of the Beldray Guarantee. Such reserve was based upon managements estimate, after consultation with its property consultants and legal counsel, of the cost to satisfy the
Beldray Guarantee in light of KRUG UKs limited assets and before taking into account any other claims against KRUG UK. The maximum potential obligation of KRUG UK for rent under the Beldray Guarantee is estimated to be approximately $8,400. As
a result of this claim and the U.K. liquidation proceedings against KRUG UK, SunLink expects KRUG UK to be wound-up in liquidation in the UK and has fully reserved for any assets of KRUG UK.



33



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Additional contingent obligations, other than with respect to our existing operations, include potential
product liability claims for products manufactured and sold before the disposal of our discontinued industrial segment in fiscal 1989, guarantees of certain obligations of former subsidiaries and claims and litigation incidental to our businesses
for which it is impossible to determine their ultimate liability, if any, or which are immaterial in amount. We are currently in the process of liquidating two dormant subsidiaries in Germany and France and one United Kingdom subsidiary is in
involuntary liquidation. Based upon an evaluation of information currently available and consultation with legal counsel, management has not reserved any amounts for contingencies related to these liquidations.



Sarbanes-Oxley Section 404



We are currently in the process of planning for the evaluation,
documentation and testing of our internal control systems in order to permit our management to be in a position to report on, and our independent auditors to attest to, our internal controls over financial reporting as of June 30, 2008, as
required by Section 404 of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). While we currently are planning for timely completion of such documentation, testing and evaluation, there can be no assurance that we will be able to
implement the requirements of Section 404 of Sarbanes-Oxley with adequate compliance by June 30, 2008. Should we be unable to do so, we could be subjected to investigation by regulatory authorities, incur litigation costs and/or suffer
loss of our AMEX listing. Any such actions could adversely affect our financial results and/or the market price of our common shares. There have been discussions by SECs Advisory Committee on Smaller Public Companies to further delay or reduce
the requirements Section 404 of Sarbanes-Oxley for non-accelerated filers such as the Company. No changes to the current requirements have been formally proposed by nor is there any assurance that the SEC will propose or adopt such changes for
any companies including non-accelerated filers. In the event the requirements of Section 404 are modified, such changes could affect the timing requirements for and cost of compliance with Section 404. We incurred minimal incremental costs
related to compliance with Sarbanes-Oxley during the six months ended December 31, 2005. We anticipate that these costs will increase and become significant in future periods. Specifically, the cost of compliance with the Sarbanes-Oxley
requirements is expected to result in increased operating expenses during the fiscal year ending June 30, 2007 and subsequent fiscal years. Although we do not currently have specific estimates of these costs, the cost of the initial
implementation as well as on-going compliance with Section 404 could be particularly high for the Company due to its decentralized management structure and the fact that the three different management information systems that are in use among
our seven hospitals are not scheduled to be completely replaced by a single system until September 30, 2006.



Recent Accounting Pronouncements



In December 2004, FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets  an amendment of APB Opinion No. 29. The
guidance in Accounting Principles Board (APB) Opinion No. 29, Accounting for Nonmonetary Transactions,is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of
the assets exchanged. The guidance in that Opinion, however, included certain exceptions to that principle. SFAS No. 153 amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and
replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result
of the exchange. This statement was effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Its adoption by the Company did not have a material impact on the Companys financial condition or
results of operations.



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In December 2004, FASB issued SFAS No. 123 (revised 2004), Share-Based Payment.SFAS No. 123 (R) replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123
(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that
are based on the fair value of the entitys equity instruments or that may be settled by the issuance of such equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in
share-based payment transactions. The Company adopted this standard effective July 1, 2005 . The effect of adoption of this standard by the Company for the fiscal year ending June 30, 2006 is estimated to be a decrease of approximately
$550 in the results of operations.



In March 2005, FASB
published FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligation  an interpretation of FASB Statement No. 143. Interpretation 47 is intended to result in (a) more consistent
recognition of liabilities relating to asset retirement obligations, (b) more information about expected future cash outflows associated with those obligations, and (c) more information about investments in long-lived assets because
additional asset retirement costs will be recognized as part of the carrying amounts of the assets. Interpretation 47 clarifies that the term conditional asset retirement obligation as used in FASB Statement No. 143, Accounting for
Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity.
The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Uncertainty about the timing and (or) method of settlement of a conditional asset retirement
obligation should be factored into the measurement of the liability when sufficient information exists. Interpretation 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement
obligation. Interpretation 47 is effective no later than the end of fiscal years ending after December 15, 2005. Implementation of this SFAS is not expected to have a material impact on the consolidated financial statements of the Company.



In June 2005, FASB issued SFAS No. 154,
Accounting Changes and Error Correction, a replacement of APB Opinion No. 20 and SFAS No. 3. This statement applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and
reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods financial statements of a voluntary change in accounting principle unless it is impracticable. APB Opinion No. 20
previously required that most voluntary changes in accounting principles be recognized by including in net income of the period of the change the cumulative effect of changing the new accounting principle. SFAS No. 154 is intended to improve
financial reporting because its requirements enhance the consistency of financial information between periods. SFAS No. 154 requires that a change in method of depreciation, amortization, and depletion for long-lived, non-financial assets be
accounted for as a change in accounting estimate that is effected by a change in accounting principle. APB Opinion No. 20 previously required that such a change be reported as a change in accounting principles. SFAS No. 154 is effective
for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Statement does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition
phase as of the effective date of SFAS No. 154. Implementation of this Standard is not expected to have a material impact on the consolidated financial statements of the Company.



In November 2005, the FASB issued FASB Staff Position No. 45-3, Application of FASB Interpretation
No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners (FSP FIN 45-3). The guidance in this staff position amends FASB Interpretation



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No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (FIN 45) by adding minimum revenue guarantees to the list of example contracts to which FIN 45 applies. Under FSP FIN 45-3, a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. One example cited in FSP FIN 45-3 involves a guarantee provided by a healthcare entity to a non-employed physician in order to recruit such physician to
move to the entitys geographical area and establish a private practice. In the example, the healthcare entity also agreed to make payments to the relocated physician if the gross revenue or gross receipts generated by the physicians new
practice during a specified time period did not equal or exceed predetermined monetary thresholds. FSP FIN 45-3 is effective for new minimum revenue guarantees issued or modified on or after January 1, 2006. The Company adopted FSP FIN 45-3
effective January 1, 2006. SunLinks accounting policy for physician guarantees issued prior to January 1, 2006 is to expense guarantees as they are paid. However, under FSP FIN 45-3, the Company will expense the advances paid to
physicians over the period of the physician recruiting agreement, which is typically two to three years. The Company is currently assign the impact of adoption of FSP FIN 45-3 on the consolidated financial statements.



In November 2005, FASB issued Staff Position (FSP) Nos. FAS 115-1
and FAS 124-1, The Meaning of Other Than Temporary Impairment and its Application to Certain Investments. This FSP addresses the determination as to when an investment is considered impaired, whether that impairment is other than
temporary, and the measurement of the impairment loss. This Staff Position is effective for periods beginning after December 15, 2005 with earlier application permitted. Implementation of this guidance is not expected to have a material impact
on the consolidated financial statements of the Company.



Related Party
Transactions



A director of the Company and our
company secretary (who was a director of SunLink until November 2003 and is now a director emeritus) are members of two different law firms, each of which provides services to SunLink. The Company has paid an aggregate of $300 for legal services to
these law firms in the six months ended December 31, 2005. Another director received $3 during the six months ended December 31, 2004 as a fee for being a letter of credit obligor for up to $200 of SunLinks revolving credit loans
assumed in the HealthMont acquisition. The letter of credit obligation expired in September 2004.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



We are exposed to interest rate changes, primarily as a result of borrowing under our credit facility completed in October 2004. At December 31,
2005, borrowings under the facility of $9,222 have been drawn at an interest rate based upon LIBOR. A one percent change in the LIBOR rate would result in a change in interest expense of $92 on an annual basis. No action has been taken to mitigate
our exposure to interest rate market risk and we are not a party to any interest rate market risk management activities.



ITEM 4. CONTROLS AND PROCEDURES



Management of the Company, with the participation and under the supervision of the Companys Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the Companys disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this quarterly report. Based on this evaluation the
Chief Executive Officer and Chief Financial Officer have concluded that the Companys disclosure controls and procedures are effective as of the end of the period covered



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by this periodic SEC filing to provide reasonable assurance that material information required to be disclosed by the
Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commissions rules and forms. There has been no change in
the Companys internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the
Companys internal control over financial reporting.



The
Companys management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Companys disclosure controls and internal controls will prevent all error and all fraud. A control system, no matter how
well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits
of controls must be considered relative to their costs. Because of inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have
been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of the control.



The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under
all potential future conditions; over time, a control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and not be detected.



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PART II. OTHER INFORMATION



Items required under Part II not specifically shown below are not applicable.



ITEM 4. SUBMISSION OF MATTES TO A VOTE OF SECURITY HOLDERS



On November 7, 2005, the Company held its Annual Meeting of Shareholders. At the
meeting, four directors, Dr. Steven J. Baileys, Gene E. Burleson, Michael W. Hall and Robert M. Thornton, Jr. were elected to two year terms expiring at the Annual Meeting of Shareholders in 2007 and the Companys 2005 Equity
Incentive Plan was approved by the shareholders. 5,586,107 votes were voted in favor of electing Dr. Baileys and 918,223 votes were withheld. 5,586,898 votes were voted in favor of electing Mr. Burleson and 917,432 votes were withheld.
5,604,398 votes were voted in favor of electing Mr. Hall and 899,932 votes were withheld. 5,546,482 votes were voted in favor of electing Mr. Thornton and 957,848 votes were withheld. 2,895,370 votes were voted in favor of approving the
2005 Equity Incentive Plan and 1,482,694 votes were voted against the 2005 Equity Incentive Plan.



ITEM 6. EXHIBITS



Exhibits:



|     |  |                                                                                                                                                  
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|31.1 |  | Chief Executive Officers Certification Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.                                       
|     | 
|31.2 |  | Chief Financial Officers Certification Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.                                       
|     | 
|32.1 |  | Chief Executive Officers Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|     | 
|32.2 |  | Chief Financial Officers Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



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SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, SunLink Health Systems, Inc. has duly caused this
report to be signed on its behalf by the undersigned thereunto duly authorized.



SunLink Health Systems, Inc.By:

/s/ Mark J. StockslagerMark J. StockslagerPrincipal Accounting Officer




Dated: February 14, 2006



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